What are Profit Margins and Why Do They Matter

What are Profit Margins and Why Do They Matter?

Profit margins (also called margins) matter because they are the percentage of sales that the business owner keeps. Sales of $100,000 with a profit margin of 20% generates a profit of $20,000. In other words, 80% of the sales value was used to generate the sale, leaving 20% for the business owner.

A change in margin has a greater impact on profit than an equivalent percentage change in sales. The lower the margin to start with, the bigger impact a change in the margin has.

In our example above, to achieve a $1,000 increase in profit with no change in margin, we need to increase sales by 5%, or $5,000:

Alternatively, to achieve the same increase in profit with no change in sales, we need to increase margin by just 1%:

Gross Profit Margin and Net Profit Margin
Profit can be further broken down into gross profit and net profit. Gross profit is the profit after deducting just the costs directly incurred to deliver the product or service. These direct costs, often called cost of sales, will vary as the sales volume varies.

When a bike shop sells one bike, there is a cost of that sale being the cost the shop paid for the bike. If the shop sells a bike for $1,000 after paying $600 for it, it makes a 40% gross margin on the sale.

Presuming a business has similar gross margins across all its products, the cost of sales will change approximately in proportion to sales.

Let’s say our bike shop sells $400,000 worth of bikes in a year, with an average gross margin of 40%. Gross profit is $160,000:

Now, let’s say the shop has other expenses of $100,000 including rent, power and wages. These expenses are generally fixed, regardless of sales. These expenses are deducted from the gross profit to get to net profit.

Our bike shop has a net profit of $60,000 and a net profit margin of 15%.

While net profit is ultimately what matters, because net profit is what we keep, our gross margin is where we can influence our results. We make one-off decisions regarding fixed expenses such as whether to rent an expensive shop in a high foot-traffic area or a cheaper shop in a quiet side street. But once these decisions are made, we can’t change them month to month.

Where we can make a difference in the short-term is by focusing on our sale prices and deals with suppliers to try and improve our gross margins. I.e., widen the gap between sales and cost of sales. A small increase in gross margin converts to a large increase in net margin.

What if our bike shop managed to negotiate a lower cost from a new supplier and increased its gross margin from 40% to 50% of sales. This 10% increase in gross margin results in a 25% increase in gross profit, from $160,000 to $200,000.

The difference is magnified at net profit level. The 25% increase in gross profit converts to a 67% increase in net profit.

Margins are important and a modest improvement in gross margins, without adversely affecting other factors, can drastically change net profit. And net profit is what you can bank. It’s called the bottom line for a reason.

Contact us with your business questions.

Death by Discount

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

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.