Often, the first thing an investor asks about a business is if it is profitable. And while this is not the only factor determining business success, it is arguably the most visible. It’s a measure of financial performance. So, what does it mean to improve profitability?
Large and small businesses must work to improve profitability using one or a number of strategies. Often, it’s the slight improvement that moves the bottom line in the right direction, but sometimes there is a significant improvement that turns everything around.
Let’s look at profit, profitability, and concrete steps to increase both.
Many use the terms profit and profitability interchangeably, but distinct differences exist.
Profit is sales minus expenses. It’s calculated on the income statement, sometimes known as the profit and loss statement, and is typically reported annually.
Gross profit and net profit are two profit margins calculations derived from the income statement.
Gross profit is revenue minus the cost of goods sold. Net profit is revenue minus cost of goods sold minus operating expenses. This is the amount the IRS will tax as income.
Net profit after tax is the money you have to reinvest in the company or pay your shareholders.
Profitability, on the other hand, is a ratio of the amount of profit you make compared to your sales. It means that your company has the ability to produce more revenue than expenses.
Improving profitability allows your business to grow and compete in the marketplace.
We can use sales to illustrate the difference between the two. To turn a profit, a company must make more sales. To be profitable, a company makes more profit from its current sales.
If a company does not turn a profit after a period of time, it cannot continue to operate far into the future without constant influxes of cash from outside sources.
At some point, investors will decline to lend money as they are not receiving a return on their investment.
As a business owner, it’s important to understand that companies that fail to show a profit do not receive loans from banks or are offered less than desirable interest rates. Suppliers begin to question whether the company can pay their invoices.
Profitability allows your business to grow and compete in the marketplace. The ability of a company to become profitable will lead to it actually making a profit.
There are three ways to measure a company’s profitability.
Gross profit is derived from total sales and subtracting the cost of goods sold. Gross profit margin is gross profit divided by revenue. This percentage measures how much money you are making per sale. The higher the number, the more profitable a company’s operations are.
Investors tend to compare the gross profit margin between two like companies. If your competitor has a higher gross profit margin, there are probably areas where you can make cuts.
Gross profit margin is also a good number to look at when determining whether you should raise your prices or offer customer’s a discount on services.
Operating profit margin takes things a step further. It is calculated by taking total revenue minus the cost of goods sold plus operating costs and dividing that by total revenue. Again, you’ll get a percentage.
By adding in operating costs such as rent, payroll, utilities, insurance, marketing, and various other costs, you have a more accurate picture of how your expenses affect your bottom line.
To improve this margin, consider how to streamline the costs associated with operating your business.
Net Profit margin takes it yet one step further. It is calculated by taking total revenue – total costs divided by total revenue.
Total costs include the cost of goods sold, operating costs, interest payments, and taxes. Now you can see how interest payments and taxes affect the bottom line.
Profitability is affected by either an increase in one factor or a decrease in another.
For example, you can sell more by expanding your offering of goods and services or ramping up your marketing efforts. Or you can reduce costs by negotiating with suppliers, managing your assets, or automating processes.
Completing an income statement and knowing your profit margins allows you to pinpoint where to start looking at making improvements.
Here are a few ideas to get you started:
To increase profitability, you need to be diligent about managing costs or even reducing costs. Every line of your financial statements provides an opportunity to affect costs.
To understand where the most effective cost-cutting measures are, you need to understand activity-based costing.
Think about producing a product or providing a service – now think about the costs associated with that activity. This includes workers’ salaries, raw materials, and even marketing costs.
Once you determine the real costs, you can pinpoint cost-cutting measures.
To manage costs, here are a few things you can do:
Each product or service you provide has a price to produce and the price you charge to the customer. Each of these areas must be analyzed to ensure you are making a profit.
Check out what your competitors are charging and determine what differentiates your product from theirs.
Consider changing your sales prices to match the market but do this wisely. You don’t want to risk alienating your existing customers or pricing yourself out of the market.
There are many ways to raise your sales price including annual price hikes or pairing existing products with new ones for a higher cost.
Evaluate your customer base. The 80/20 rule states that 80% of your profits come from 20% of your products. As a result, it may benefit you to concentrate on those top-level products or services.
Just like the price hikes, you must ensure that you are not alienating customers loyal to your other 80% of products. These products and services are still valuable, but they are not the primary focus of your daily work.
Another focus should be on your customer base. Your best customers already love you and your product or service, so offer them more of what they are looking for.
You could upsell premium products, cross-sell products that work well with the ones they’ve already purchased, or develop new services to meet their specific needs.
We’ve touched on getting the best price from your suppliers, but it goes deeper than that.
You must not sacrifice quality just to satiate your bottom line. But you can look at other suppliers of the same quality to ensure you are getting the best deals.
Suppliers may be able to budge their prices based on the volume or time they’ve been a customer.
If you are getting your product from many different sources, see if you can get both materials from one supplier (at a discount, of course). Small businesses can often combine forces to place larger orders. It never hurts to ask.
Cutting costs is a theme that runs through business owners when things get tough. The first place to look is waste, and this could be anywhere.
If your best customer decided to cut their order, would you have enough other customers to make up the difference? We just discussed that 80% of your profits come from 20% of your customers. We can look at this in two ways.
First, are you putting all of your eggs in one basket? If a product or service works great for one customer, find another customer to sell to.
On the other hand, if you are spending time catering to a customer with lower sales or profit, perhaps your focus should be elsewhere.
At the same time, it’s important to look at your business as a whole.
Depending on your product, you could offer a loss leader, which means that you sell a product at a loss in the hopes that the client will order a more expensive product later. Look at your products as a whole and see what benefits each has toward your bottom line.
It takes time to build trust with your customers. Make sure that your profit efforts align with your long-term goals.
No matter how successful you are, you should never rest on your laurels.
Unfortunately, none of us have a crystal ball to see into the future, but we can prepare ourselves for the worst-case scenarios.
It’s easy to get tunnel vision when running your business. You are concentrating on inventory, suppliers, production, making payroll, developing products, purchasing equipment, and all the other daily operational decisions you face.
Market research accomplishes one of the best ways to answer questions about what products you should manufacture and where you should find new customers.
Browse social media to see what is trending or where your target market has pain points, and then think about how your existing product or service could fulfill those needs. Think outside the box.
If you usually sell to one group of customers, think about how you could sell to another group.
But before jumping right into a new venture, research how much it will cost to produce a new product or modify an existing one.
Consider labor, equipment, materials, and expertise required for expansion.
Compare costs against the demand for the product and think about how fast you’ll make up your new investment.
Look at your processes and see where you are wasting time or effort.
For example, if you print out invoices and stick them in the mail, look into paperless invoicing.
Make it easier for customers to pay through bank transfers or debit/credit accounts. You save money on supplies and stamps and possibly get paid sooner—helping your cash flow.
Use this rationale with every handoff and process. Evaluate each employee’s role and ask yourself if any of those could be combined.
Automation or even a new piece of software that provides multiple functions might be possible. Research how your competition operates and emulate its processes if they thrive in a particular area.
Large and small business owners need to be concerned with profit and profitability. By preparing your income statement, you’ve laid the groundwork. A few calculations and you’ve got profit margin percentages.
You can make small and large adjustments to turn those numbers around with that information. There’s so much that goes into running a business; taking the time to look at profitability is a critical step in its success.
If you are profitable, congratulations—but don’t rest on this good news. Make it better. If you are not profitable, that’s ok—for now. You now have a place to start making improvements.
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