Death by Discount

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Death by Discount

Is Your Discounting Killing Your Business?

You sink a lot into your business — your time, money, stress. But there is no guarantee your business will ever repay you. The potential profits will stay hidden until you uncover them. To uncover them you need a high profit business design.

The key to designing your business for high profits is to focus your energy in the right places. Perhaps the most dramatic and easiest improvements can come from focusing on your prices. An example below will show you how increasing prices by 10% can increase bottom line profits by 50%.

But price increases will lose you business right?

Our natural tendency is to undervalue our products and services. It’s personal — we find it hard to ask for a ‘high’ price; especially when we’re starting out in business. We think we have to offer more for less to get business.

But that is usually not the case. People will pay what they perceive your products and services to be worth. You do provide value to your customers. Chances are you are not charging enough for that value.

How much should you charge?

First make sure you know your numbers. Calculate the true cost of delivering each unit of product or service. This includes the purchase cost to you of the product, direct labour costs, freight in and out, your time etc. Include every cost that will increase when you sell one more product or service unit. This is the cost of sales in the example on the following page.

Next calculate your profitability. The business in the example below sells wooden ornaments. They are currently selling 2,000 units per year at an average sale price of $100. Each product costs the business $65 all up, delivered to the customer. After deducting the cost of sales of the 2,000 units per year ($130,000), and fixed indirect expenses of $30,000, the net profit left over for the business owner is $40,000.

If the business is typical they could probably get a bit more for their products. Say they increase their prices by 10%. Assuming their volume of sales stays the same look at the change in net profit. The 10% price increase gives a whopping 50% increase in net profit!

But if you increase your prices you’ll sell less won’t you?

Well that depends on the product. If you are undercharging now you will lose little if any sales volume. But assume your customers are price sensitive. Maybe you face stiff competition. How much can your sales volume go down, before you lose out on your bottom line?

The next example shows volume dropping by 22% in response to the 10% price increase. At this change (a fairly dramatic response to the price increase) the business still maintains the same bottom line Net Profit.

So if sales volume falls by more than 22% profit goes down, less than a 22% volume drop and profit goes up.

Beware of going the other way

And if you’re tempted to discount your prices to gain more business, the increase in volume needed to maintain your profit is even more dramatic. Look at this example with a 10% decrease in price:

A 40% increase in sales volume is needed to maintain the $40,000 net profit. This may be possible if it’s combined with a significant marketing campaign. But that is a big increase in anyone’s books.

The more differentiated your product or service, the less sensitive the sales volume is to price changes. Differentiate yourself from your competition with your branding, your service and relationships with your customers. Unless you are selling a true commodity, you can maintain sales volume with higher prices.

Real Life Examples

If you are still nervous about increasing your profits let me tell you a real example. I sent a newspaper article to a client about a competitor of hers. The article gave her competitor’s prices which were significantly higher than hers. She immediately put her prices up to match. With no other major changes in her business, a year later her profits were up 59%.

And a hair salon client of mine once told me they couldn’t understand why they weren’t busier. “We charge less for a better quality service than our competitors so why aren’t we flat out?” She asked. After asking her why her prices were lower, she could give me no good reason. So after a few weeks of thinking about it she increased all her prices. And she was amazed when she did not lose a single customer.

Even if your sales volume decreases and your profits remain the same, it will free up your most precious resource — your time. Now you can work on developing other areas of your business, and/or take more time off.

Don’t let low prices bury your profits. If you really can’t raise your prices, improve your perceived value so you can.

Are you missing out on potential profits?

We are accountants for professionals and consultants. As an expert in your field, your knowledge generates value for your clients. Our job is to make sure that value also generates your financial success.

Contact us with your business questions.

Four Steps to Better Profits

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Four Steps to Better Profits

Few solo consultants and small firms reach the above average profits they are capable of. Most do not have the basic information at their fingertips to do so. I want to highlight four steps that you can take to greatly improve your profits and cash flow.

1. Have good financial statements

You can’t fix something until you know what is happening now. Surprisingly, many small business managers have no idea how their business is going. Good financial statements are the starting point to measure the results of the business as a whole.

To make any management decisions to improve financial performance, you need financial statements that are:

  • Accurate: All relevant business transactions should be processed and checks done to ensure everything is included and in the right place. Misleading information can do more harm than no information.
  • Timely: It is no use looking at how you did 18 months ago. To make meaninful changes you need to know the results of your recent efforts. Monthly, or at least quarterly, accounts will keep you on the pulse of your business.
  • Relevant: Well designed accounts provide a simple, clear picture of your business’s results. Unstructured and poorly thought-out accounts will confuse you. Make sure you have accounts that show the information you need, and nothing else.

2. Have a financial plan

You need financial statements to show how you’re doing. But with nothing to compare them to, it is hard to know whether the results are good or bad. When you compare your results to a plan, or budget, you can see where you are succeeding and where you are not.

The financial planning process serves two key purposes:

  • First, the planning process reveals the feasibility of what you are trying to achieve. Often people create a elaborate business plan with ambitious plans. When it comes to crunching the numbers, they realise it just isn’t going to work. Don’t start on a business without knowing the numbers make sense.
  • Second, the plan is the yardstick to measure your actual results against. Only by doing this can you see where things are working out and where they are not. Then you know where to focus your energies to put things right.

Without a plan you are working and hoping for the best. With a plan, you are following a thought out route with a much higher chance of reaching your destination. By regularly comparing your actual results to your plan, you will quickly see what is working and what is not.

3. Analyse results by segment

Your financial statements will show your overall business results. To identify exactly where these results can be improved, you need to know which part of your business is working and which isn’t.

A good accounting system will help you separate your results to show profit by any type of segmentation. This may be by client, service type, region if you have clients in more than one area, or by staff member if you employ other fee earners. By examining different segments, you will undoubtedly find that some areas of your business are subsidising others and the results may surprise you. It often feels like the business that is keeping you busy is making you money, but the results can reveal a different story. Armed with this knowledge, you can either fix the under-performers or put more resources into the over-performers.

David Maister wrote in his book Managing the Professional Services Firm, that it is not unusual for firms to find that 120% of their profits come from 80% of their clients. In other words, they are losing money on 20% of their clients. Those 20% are draining energy that should be used on your good clients. But until you know who they are, you can’t fix it.

4. Monitor key performance measures

You can’t track all your results all the time, but you can closely monitor two or three key indicators. When you know what you’re trying to achieve, you can identify the most important areas for you to achieve it. By closely monitoring these, you will have rapid feedback to learn and improve your performance.

The measures may change as your business evolves, and they can relate to any area of your business. The popular Balanced Scorecard approach is to divide your business into four areas and choose the objectives within those that will make the biggest difference to your results. This helps ensure you are looking at your business as a whole:

Learning and innovation

What professional and personal development will increase your ability to deliver value to your clients, profitably? How do you measure your development in this area?

Internal Processes

How can you improve your efficiency through increased skills, technology or systems? The smoother your business runs the more time you have to deliver your services.

Customers

How will you generate new work from new or existing clients, and how do you measure your success? You might track the number of new enquiries, the percentage of those that become clients (conversion rate), or the number of higher value services provided.

Financial

Where is the biggest potential to improve your financial performance? It could be increased fees, better profit margins, or improved debtor collection and cash management.

Every business will identify their own critical success factors, but they should be based on the cause and effect relationship.

Do you have gaps in the above areas? If so, by getting on top of your management information you could stop your profit leaking out.

It doesn’t need to be complicated or expensive to put these four measures in place. If you want some help, get in touch.

Entertainment Tax Explained

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Entertainment Tax Explained

As a professional or consultant, your business success relies on developing and nurturing relationships. So choosing to pay for a client’s lunch, or shouting a Christmas dinner for staff and associates, is part of doing business.

I am guessing, however, that your invitations do not normally extend to the person you’ve dealt with at IRD. Whether or not that is the reason, the taxman hasn’t quite come to the party.

The general rule, for income tax purposes, is that expenses incurred in deriving income or running your business are fully deductible. I.e., we deduct the full expense from our income when calculating our taxable profit. However, the Income Tax Act limits the deduction of certain entertainment expenditure to 50% of the cost. The rationale behind the law is that these expenses provide a significant private benefit in addition to any business benefit.

So what expenses are limited and what can we claim in full?

50% Deductible Expenditure

The Income Tax Act limits the tax deduction to 50% of spending on:

  • Corporate boxes, marquees etc at entertainment events and food and drink provided there
  • Holiday accommodation or pleasure craft
  • Food and drink provided away from your business premises, or at your premises if you’re having a social function

If you reimburse an employee for expenditure on these items, while the reimbursement may be a tax-free allowance to the employee, the cost will remain 50% deductible to the business.

Fortunately, not all expenditure on food and drink is subject to the 50% limitation.

Fully Deductible Expenditure

You can claim 100% of:

  • Meals and accommodation when travelling for the principal purpose of business, unless you are also entertaining a business contact or attending a function
  • Light refreshments provided at work including tea and coffee
  • Light refreshments at a conference or professional development workshop
  • Light refreshments that are incidental to a function, conference or seminar put on to promote your business
  • A meal at a conference where the professional development or learning time exceeds four hours
  • Meals for staff working overtime
  • Food and drink when overseas on business

Consider These Examples

  • A business consultant puts on a seminar after work for existing and prospective clients to promote the value of business planning for professionals. Drinks and nibbles provided are incidental to the primary purpose of the seminar and are therefore fully deductible.
  • An Auckland architect travels to Wellington to discuss an upcoming project with a client. After their meeting, the architect takes the client to dinner. If the architect pays for both meals, it is entertainment and therefore 50% deductible. If the architect just pays for their own meal, it is fully deductible as a travel cost.
  • The three partners of an Auckland IT Consultancy go to Fiji for an annual planning retreat. As food and drink overseas is not subject to the entertainment limitation, all expenses are fully deductible. However, if part of the expenditure is purely entertainment, this will be subject to Fringe Benefit Tax.

When Does the Expenditure Become a Fringe Benefit?

Entertainment, as above, refers to a business entertaining its staff or business contacts. If benefits are provided to employees, including shareholder-employees, which the employees can enjoy at their discretion, or it is provided overseas, it is no longer entertainment expenditure but becomes a fringe benefit.

For example, you buy your employee a restaurant voucher to use if or when they choose. This is a fringe benefit.

While Fringe Benefit Tax is a whole other area, basically, the business can claim the full cost of providing fringe benefits, but has to pay Fringe Benefit Tax on the value of the benefits.

What About Gifts?

If you give your staff cash, it will generally be considered part of their remuneration and subject to PAYE. Non-cash gifts to staff however are considered fringe benefits. As above, these are fully deductible to the business but subject to Fringe Benefit Tax.

The good news is that non-cash gifts of up to $300 per quarter (or $1,200 per year) per employee are generally exempt from Fringe Benefit Tax. Note however that if you exceed this threshold, the whole benefit is subject to Fringe Benefit Tax.

As the Fringe Benefit Tax rules apply to employer-employee relationships, gifts to clients and other business contacts are treated differently. They are generally fully deductible; however, gifts of food and drink to business contacts are subject to the 50% entertainment tax limitation. Keep this in mind when buying those Christmas hampers.

In Conclusion

The business of professionals and consultants is built on relationships, so you may choose to spend some money showing your appreciation of those relationships. But before you splash out, make sure you understand the tax implications and manage your options accordingly.

Robb MacKinlay is an accountant and business advisor to professionals and consultants, helping them convert their expertise into profitable business.

Contact us with your business questions.