This article is by Lauren Owen, previously a partner at Business Resource Services (Profit Mastery) for more than 15 years. Out of the Top Ten ways to build Profit and Value, Profit mastery’s Profit Gap Financial Reports give you the financial information you need to make the decisions recommended in each of the Top Ten recommendations in this article.
Top 10 Ways to Build Profit (and Value) in Your Business When Raising Prices Isn’t An Option
Today’s economy has resulted in a competitive environment that often makes it difficult to raise prices. Revenues have decreased dramatically in many cases. As a result, profits have taken a hit and some owners who were expecting to transition out of their businesses have had to delay their exit plans.
Many of us have done as much cost cutting as possible. (Does the phrase “to the bone” ring a bell?) But based on the evidence we’re seeing from around the country in many different types of industries, we believe that opportunities to build profits remain. And profits are more important than ever for your company’s day-to-day survival and long-term health, and for laying the foundation for a successful ownership transition.
If you plan to sell your business to a third party, the majority of its appraised value will be based on its ability to generate profits and cash flow. Higher profits and cash flow generally equal higher value.
If you are going to sell or gift part of your business to family members, you might be thinking about seeking a lower appraised value to minimize your tax impact. But keep in mind that the company’s future survive-ability will ultimately depend on its profitability. Assuming that you are not one of the fortunate people whose retirement funds are securely in place, a large part of your estate is tied up in your business. You’ll likely be serving as “the bank” for at least part of the deal. The better the profits, the better your chances are of getting paid off and reaching your retirement goals.
While there are a lot of factors that affect profitability, we’re going to focus on gross profit–that is, what’s left after you subtract from your sales the costs of selling your product (called cost of goods sold) or delivering your service (cost of sales). While it is critical to keep an eye on all costs, in almost every business model the largest percentage of costs are tied up the company’s costs of goods sold. Because of this, even small changes in margin can have huge impacts.
Let’s say your sales are $1,000,000 million and your gross profit is $340,000. Stated as a percentage, you have a gross margin of 34%, which means that after you’ve paid for the goods that you sold, 34 cents out of every dollar you make in sales is “left over” to cover all of your other operating expenses. However, your industry peers’ gross margin is 35%. That 1% difference might not seem like a lot, until you realize that if you had achieved that same 35% margin in your company, your gross profit would have been $350,000. That’s $10,000 more that could have gone straight to your bottom line, assuming none of your other operating costs change.
Here’s my top 10 list for increasing profit and company value when there’s downward pressure on prices.
1. Set A Gross Profit Goal. Measure It Properly. Watch It Like Crazy.
Start by ensuring that your accounting system is categorizing the right costs in this area. You’ll need the ability to compare your company to others in your industry, and to do so, you’ve got to compare apples to apples. Be sure your cost of goods categories match your industry peers’. Industry benchmark studies, sometimes available from your trade association or The Risk Management Association (RMA), can provide comparative data so you can learn what type of gross margins the profit leaders in your industry achieve and set appropriate gross margin goals. Get profit and loss statements with columns that show your numbers in both dollars and percentages. That way you can see changes in gross profit in absolute terms, not just changes due to sales increases or decreases. You should track your gross margin on at least a monthly, if not weekly, basis so you can take quick action.
2. Tune Up Your Product Mix
Once you have your costs in the right buckets, you have the “high level” view of gross profits–your company’s overall gross profit, which is made up of the gross profit of each of the items you sold. This, in turn, adds up to the total gross profit of each of your product lines. This adds up to the gross profit in area, or department, of products or services. While you can measure your historical gross profit this way, ultimately the only way to really manage it going forward is to drill down backwards:
Total Gross Margin
Gross Margin by Department
Gross Margin by Product (or Service) Line
Gross margin of each SKU (or Stock Unit) or Job
Breaking down your gross margins in this way can help you identify which aspects of your business are helping you meet your goals and which might be getting in the way. For example, I once coached a jeweler who was a member of an industry performance group. He was distressed about his low gross margin percentage as compared to his group peers. He was also proud of his large watch department and the number of watches he carried in each product line. But when we took a look at the gross margins of each of his watch lines, we found that there were only a few that generated what he considered an acceptable margin. And in each line, there were even fewer styles in each watch line that sold on a regular basis and produced a good margin. Although his margins in his other departments were higher than the group’s average, his low watch margins served to drag down his company-wide gross margin. As a result, he trimmed his watch department way back to only the top selling lines and in those lines, only the top margin producing and selling styles. As an extra bonus, he generated more cash from carrying a lot less inventory.
To do this type of analysis, you’ll need a good accounting system that can generate historical data that shows gross margin by department, by product or service line and by SKU (or job). A capable accounting professional should be able to get you set up to do this.
3. Look at Pricing and Product Strategy
As we noted earlier, economic conditions have resulted in downward price pressures that can make it very difficult to raise prices, especially if you carry goods or deliver services that are identical to everyone else’s. Customers can and will shop the competition in town and on the web for cheaper options. When you offer unique products and services, it’s a lot harder for them to price compare. You can’t be all things to all people. When thinking about adjusting your mix, think about what your company, and your company alone, can do particularly well.
Find other ways to add value to or customize your product or service. For example, some community pharmacies offer home delivery, a service that automatically coordinates prescription refills, and custom compounded formulations (with higher margins). Some retailers are creating more custom designs and offering first dibs on new products. Others offer other “add-on” products: warranties, cleaning, or “tune-ups” as part of their selling price. Small wineries are selling direct to market via wine clubs, thereby taking back margin that previously went to distributors. All of these strategies have helped other businesses, at the very least, hold their prices, retain or even increase market share, and at times increase prices. The result: higher margins.
4. Discount With Purpose, Not from Habit
If you need to discount to stay alive, by all means do so. But do it strategically by knowing how much more you’ll need to sell at the lower price to make up for the discount. Also, don’t make it too easy for your sales people to automatically discount to make a sale: if you pay your sales people on commission, base it on gross margin, not top line sales, so that if they discount to make the sale, they’ll feel the pain as well.
5. Buy Better and Smarter
Buy products with your target margin and your customers’ price points in mind. For example, your target margin is 50%, and your research shows that $200 is the average selling price point at which your customers buy. Find products that you can buy for $100 and that your customers will think are a good value at that $200 price point. Also, negotiate discounts for early payments or bulk purchases from your vendors. Look for other sources that are more cost effective.
One company examined their purchases and found that managers frequently placed last minute orders without paying attention to price, costing the company money. Once they consistently centralized the purchasing function and required purchase orders for payments (particularly with primary vendors), it problem of extra costs associated with rush orders was eliminated.
6. Introduce Counter-Cyclical Products
If you have a slow season, think about introducing counter-cyclical products or services to your core business to generate incremental profits and cash flow. One company that sells floor based heating systems (with a traditional slow summer sales season), introduced a de-icing product that could be sold and installed during the summer. They added $80,000 to their bottom line in the first year of the new product
7. Take Action
A very wise person said that hope is not a strategy. Take action when needed. Don’t let problems linger. If you made a buying mistake, don’t hold on to the product. Take the hit and get it out the door so you can generate cash to buy or produce products that will sell.
8. Look Around You
Find out what the leaders in your industry are doing. As long as they are not direct competitors, most are willing to share ideas. Join a peer group that shares numbers, not just war stories. I know many businesses that are alive and flourishing even in today’s challenging times because of ideas and insights they gained from such groups.
9. Think Outside the Box
Look outside your industry for ideas. We can all learn lessons from how other industries and business models are maneuvering through these times. The New York Times has an excellent online series called “How I Saved My Company” that features videos of business owners sharing how they got their companies through the recession.
10. Nothing Ventured, Nothing Gained
Ships are safest in harbors, but that’s not where they belong. Are you spending too much time idling in your safe harbor? Sometimes you have to make strategic decisions that are outside the prevailing wisdom. While many are cutting back on advertising and marketing, now might be the right time to increase your visibility. Invest in sales training. Look at picking up some of the substantial talent and experience that’s currently on the market.
Bottom line to increase your bottom line? Act with the conviction that there are profit opportunities out there. Don’t abandon your exit plans just yet. Think of this period as an opportunity for more time to build company value, develop a thought-out transition plan and mentor your successor(s).
Note: As noted above, since this article was originally written, Profit Mastery has added an additional tool to the tool box that can help shed light on each of the ten actions described in the article. Profit Gap financial reports are automatically (easily) downloaded from your QuickBooks files…the information is the reports is based on the Profit Mastery system and highlights the financial information you need to know to make the decisions that will make your business more successful and profitable.