Calculating business profitability is relatively straightforward, but keeping a company profitable takes persistence. So, what factors impact profitability?
Spending time each month to see where you stand financially and making minor adjustments can give you peace of mind and help you stay on track.
Many factors affect the profitability of a company. Smart business management needs to focus on the ones you can control and that make a difference to the bottom line.
Let’s look at what profit means, what factors affect a company’s profitability, and what you can do to move that bottom line number in the right direction.
What is Profit to a Small Business?
Profit is total revenue minus total expenses and is a key indicator of how your business is performing. Investors use it to determine whether they should lend money or buy shares in a company.
For a small business owner, it can help you determine whether you need to cut costs, raise your prices, take out a loan, or expand your product line.
There are three types of profit:
- Gross profit is revenue minus the cost of goods sold. Gross profit can help pinpoint how efficiently a company uses labor and supplies.
- Operating profit is gross profit minus operating expenses minus depreciation/amortization. This number shows the health of a company.
- Net profit is total revenue minus total expenses. The bottom-line number on the income statement considers all operating, financing, and investment activities.
What is a Profit Margin?
Profit margin calculates the percentage of sales that resulted in profit. Just like there are three types of profit, there are the same three types of profit margin—gross profit margin, operating profit margin, and net profit margin.
When you hear about a company making a profit, it refers to net profit. Focusing on the bottom line, the net profit margin is calculated by taking net income divided by sales (or revenue). This percentage represents what a company has left over after incurring all relative costs associated with producing a product or providing a service.
Knowing your gross and operating profit margins helps you get more specific about your actions.
What Causes Low Profitability?
In any business, there are many factors affecting profitability—some you can control, and others you cannot. If a supplier raises the cost of necessary inventory, you’ll bear higher production expenses and it will affect your bottom line.
You can either order less, raise your prices to make up for the cost, or search for a new supplier. If you do nothing, the result is likely lower profitability.
Other things that may result in lower profitability include a client who orders less than usual, discounting your pricing to bring in more sales, purchasing new equipment, changes in your industry, and the new competition in the market resulting in lower sales.
It’s important not to panic but to examine your margins and what numbers affect them. Then you can make plans to deal with the changes.
What Determines a Company’s Profitability?
There are many reasons a company may not be turning a profit. We’ll look at the four main factors that affect profitability: price, quantity, variable, and fixed costs.
Price
Profit is based on revenue and expenses, and one way to affect profitability is to ensure your product or service is priced correctly. There are several factors to look at in considering how much to charge:
- First, calculate how much it costs to produce a product or service. Look at raw materials, time, costs to operate machinery, labor costs, and more. Make sure the price you charge covers that cost.
- Second, research your competitors to see how much they charge for the product or service. This gives you a baseline of what the market will bear. Set your price between what it will take to cover your costs and what it takes to remain competitive. If you set your price and it is not profitable, you’ll need to consider cutting costs in other areas.
Price depends on several factors. You can position your product as a low-price leader or charge a premium. If you go for the low-price strategy, ensure you can cover the difference with another product or service or that the loss leader leads to the customer purchasing a higher volume product or service, otherwise, you’ll notably decrease profits.
If you charge a premium for your product or service, justify the higher cost to your customer through your reputation, materials, or a higher-value product. This is called your Unique Core Differentiator.
Quantity
The second factor affecting profitability involves the volume of sales. Again, there are a couple of strategies to increase the quantity:
- You could grow your number of clients while keeping your product line steady. Check your marketing strategy and search for new uses for your product or service. If you sell a product to a manufacturer, can you also sell it to consumers?
- You could increase your product line and upsell to your current clients. Start by looking at your current client’s needs and seeing where you could provide complimentary products. Educate your customers on how they could improve their process with your product.
Both of these strategies involve sales, and that can be scary. While you don’t want to be perceived as a pushy salesperson, use the approach that you care about your clients and offer products or services that help them.
Variable Costs
It’s essential to understand how costs affect revenue. Variable costs change based on your increased revenue. Labor costs and raw material costs are two items that will increase when you produce more products.
If you decide to produce more products, you must understand how the operating costs will affect your bottom line. Don’t forget to consider the time and energy costs associated with production.
Let’s say your strategy is to ramp up sales by producing more items. In theory, this is a good idea. Take your forecast into the future and determine your breakeven point. If you run the numbers and the cost of producing the items puts you in more debt, you might want to rethink your strategy.
Fixed Costs
Other costs, such as rent, insurance, and other overhead costs, do not change monthly. The predictability of these costs makes it easier to factor into your profitability calculations.
It’s essential to understand how these factors affect your bottom line and to adjust the price of your product or service, so you have enough funds to cover these costs. You can also affect these costs by renegotiating rates or shopping for alternatives where possible.
What Do We Do Next With These Factors?
These four factors each play a crucial role in determining profitability, and each can be looked at individually or as a whole. One way of doing this is by calculating your profit margin based on each factor.
As you may recall, the profit margin is a percentage. It’s often easier to see trends up or down in percentages rather than actual costs.
For example, if you calculate your baseline percentage of variable costs as 20% and determine that this turns a profit, then you want to pay attention if those costs rise.
If those variable costs rise to 25%, then you can examine each cost in absolute numbers to see where the difference lies.
How Often Should You Monitor These Factors to Improve Profitability?
Improving profitability is an ongoing process. If you decide to make some minor improvements in pricing or costs, you should analyze your profit margin monthly to see their impact.
If you make significant changes that take a few months to complete, you can monitor profit margins quarterly or even yearly. The point is to stay on top of your sales and costs and be ready to make further adjustments if the numbers start trending downward.
How to Increase Profitability
There are many ways to increase your profit margin.
Understand Where Your Profits Come From
The first step in increasing your profit margin is understanding where profits come from. We’ve given you some ideas already, but you must learn to read and interpret your financial statements. The balance sheet, income statement, and statement of cash flows provide insights into where your money comes from and where it goes. They are a great launching point for action.
Do a Cost Analysis
Before making any changes to your product line and deciding on purchasing property, plant, or equipment, do a cost analysis and budget to see if and when the new venture or investment will turn a profit. A few buzzwords to keep in mind are net present value (NPV), internal rate of return (IRR), and payback period. NPV is a comparison of what the money in an investment is worth today compared to the future. NPV predicts profitability. IRR is the discount rate that sets NPV to zero. You are in good shape if the discount rate is lower than the IRR. The payback period is how long it will take to recoup your original investment.
Optimize Your Team’s Productivity
Creating a mean, lean, well-oiled machine is crucial to productivity. Ensure that your staff is well-trained in their roles and that your processes are necessary and flow seamlessly from one to another. Find efficiencies by evaluating which, if any, processes can be combined or eliminated. Ask your team for advice—they often have ideas that will save time and money as they perform the task daily. At the same time, a few dollars spent upfront on sending an employee to training could pay off in the long run. Increasing efficiency could be as simple as reorganizing your office space, so the printer is closer or it takes less time to get to the break room.
Create a Budget
Creating a budget lets you know where you are currently and where you are heading. Budgets allow managers to plan ahead and make better financial decisions.
Research Your Target Market
Research before acting. Survey your customers as to their wants and needs and then research ways that you can meet them. Minor improvements to an existing product or service may allow you to raise your price substantially. Be aware of your competition to stay one step ahead. Be aware of materials in development so you can incorporate them into your product. Look at your advertising and social media strategies and determine where to improve. A lot of research can be done without a big budget.
Revamp Your Product Offers
Improve your product offerings by presenting them in a fresh new way. You could try bundling products for a lower price than purchasing them separately. If the client was on the fence about the second product, but you’ve illustrated how they work wonderfully together, you may have just made a “second” sale.
Talk to Your Vendors
Work on your relationships with your vendor. Ensure you are receiving the best possible deal on shipping and delivery. If you are a small business, see if you can partner with other small businesses to qualify for volume discounts. If you’ve been with the same vendor for an extended period of time, ask about a loyalty discount.
Leverage Credit Rewards
If you use business credit cards for purchases and pay the balance each month, search for one that gives you cash back on purchases. You could make a few extra bucks on purchases.
Expand Your Reach & Target
Expand your customer base by offering products to a new market or expanding your product line to reach a new audience. Also, upsell and cross-sell to your existing profitable customers.
The Bottom Line
Profitability may not be the sole focus of your business, but it is important.
Some of the largest companies in the world took years to become profitable, but they had substantial financial backing and a solid business plan. You may not have backing as a small to medium business, but you must have a plan.
If your company is currently showing a profit, congratulations, but don’t take your eye off the ball. Study your financial statements and determine where you can still make improvements.
Keep an eye out for bumps in the road and make adjustments to weather the storm. If you are not currently showing a profit, keep plugging away. A few improvements here and there could make all the difference.
For more ideas on keeping more of your money and making your business profitable through smart economic growth, visit our extensive library of articles focused on businesses like yours.
