The order book looks healthy and the bank balance moves much as it always has. But could you say exactly why the business made last year's profit, or what a price cut would do to it? Most owners cannot, which makes improving results or predicting the future very hard.
Understanding business profitability does not have to be complicated, and profit is not a dirty word. Cash may be king, but without profit no business survives in the long run. Here are ten steps to see what drives your profit and how to grow it.
1. The basics of understanding business profitability
Everyone connected to your business has a stake in its profit: shareholders want dividends, staff want wages, suppliers want paying, customers want you around if something goes wrong, and you want a long-term future.
At its simplest, profit means buying for one amount and selling for more. A sustainable business also delivers the right quality, price and timing, so customers see value, return and refer others. The non-financials cause the financial results:
- Upset a customer, lose the customer, and turnover falls.
- Give great service, win referrals, and turnover rises.
- Buy cheap material, waste more, and gross profit falls.
- Leave computers on overnight, energy bills rise, and net profit falls.
2. Test every decision against your cost base
Sales fluctuate, costs change and competitors arrive. You need to judge quickly what a price war, a rent increase, a cheaper supplier or outsourcing a core process would do to profit, balancing risk against reward.
Take outsourcing. The supplier's price includes their profit, and while many variable costs go, fixed costs such as rent, depreciation and heat & light often stay. Ask which costs will stop, start, continue and rise. Then weigh the long term: does it fit your strategy, are you handing over a critical process or valuable Intellectual Property, and how will it affect team morale?
3. Check your return on capital employed
A guaranteed £1,000 profit sounds attractive until you ask how much you must invest, and at what risk. £1,000 on a £1,000 stake is a 100% return; on £10,000 it is 10%. The same logic applies to your business through Return on Capital Employed (ROCE):
ROCE = operating profit ÷ capital employed × 100
It shows what you make for every £1 invested. Calculate it for the last three or four years to see the trend, then compare alternatives. If a bank pays, say, 3% while inflation runs at 5%, your money is shrinking; the stock market might return 10% with your capital at risk. A business returning 20% may well justify the effort, but one returning nearer 5% than 15% means it is time to look hard at your options.
4. Price correctly: know gross margin from mark-up
"Turnover is vanity, profit is sanity but cash is king." Treat profit as a puzzle and keep digging.
Ask "Why?" five times. By the fifth time, you'll start getting close to the real answer.
Ohno at Toyota
First, be clear how you set prices. One catering couple aiming for a 75% gross margin proudly reported "over 100%". They had added 75% to about £2.50 of ingredients and rounded up to £4.50 for a lasagne. That is a mark-up. Their real gross margin was £2.00 ÷ £4.50 × 100 = 44.4%, a long way short of 75%.
- Gross margin = (selling price less cost of sales) ÷ selling price × 100.
- Mark-up is the percentage added to cost: cost + (cost × mark-up) = selling price.
5. Understand what price movements really do
Many businesses cut prices far too readily. If price is all you compete on, you will always be on the back foot. Find what makes you remarkable, often your team's knowledge and service, and charge for it.
Suppose you buy widgets at £2.75 and sell 15,000 at £5.00: turnover £75,000, gross profit £33,750, a 45% margin. Raise the price 10% to £5.50 and you would need to sell only 12,273 units to make the same gross profit, so you could lose just over 18% of volume before you are worse off. If you honestly think you would lose fewer customers than that, do it, and do it quickly.
Price cuts work the other way. On £100,000 turnover at a 35% margin, a 10% cut leaves £25,000 gross profit instead of £35,000, unless suppliers cut too. You would need 40% more sales just to stand still.
6. Know your breakeven point and margin of safety
Your breakeven point is the level of sales where you make neither profit nor loss. Divide your overheads by your gross margin percentage: £50,000 of overheads at a 50% margin means breakeven at £100,000 of sales.
Use gross margin, never mark-up. Divide the same £50,000 by a 100% mark-up and you would wrongly think breakeven is £50,000, then trade to a £25,000 loss. If you forecast £120,000 against a true £100,000 breakeven, you have a 20% margin of safety. The higher it is, the lower your risk; if it is thin, act on prices and costs.
7. Harness the power of small movements
Fixed costs such as rent, rates and office salaries happen regardless; variable costs arise only when you make or deliver something. Small gains on either shift breakeven a long way, and most businesses could take out another 10%. Ideas include:
- Use purchasing power, join a buying group and negotiate prompt-payment discounts.
- Cut waste, recycle scrap and redesign products to use less material.
- Reduce absenteeism and non-productive time, and train more effectively.
- Rethink layouts, challenge procedures that add no value, and use IT to cut costs.
On £250,000 turnover at a 35% margin with £75,000 overheads, net profit is £12,500. A 10% price rise plus 10% off both variable costs and overheads lifts net profit to £61,250 and cuts breakeven from £214,285 to £144,230. Do the opposite, cutting prices 10% and absorbing a 10% supplier rise as overheads also climb 10%, and you make a £36,250 loss, with breakeven above £400,000. Always look for ways to pass supplier increases on.
8. Put controls in place
Breaking even at £300,000 a year means around £1,155 per working day over 260 days: dispatch more and you are profitable. It is a useful headline, but without tight control of everything behind it you can be lulled into a false sense of security.
People costs need particular attention. A survey of 1,200 workers by Yankelovich Partners for William M. Mercer found more than eight in ten said they could be more productive, by 25% a day on average. Set clear processes so everyone knows what to do and why, give supervisors an incentive to deliver on target and on schedule, and get out and see your team at work. If the systems are right and results still are not, as the saying goes, "change the people, or change the people!"
9. Budget for your own sake, not the bank's
Too many budgets exist only because a lender asked. The real reasons are to make income at least match spending, set sales targets, see which areas under-perform and spot costs running out of control. If you do not control financial performance, you will not control your cash.
Ask each department manager for a budget, combine them and justify every line against your objectives. Test it against rising inflation or interest rates, losing your best customer or person, and a new competitor. Never manipulate the numbers to fit.
10. Track the trends every month
Too many owners wait for year-end figures, then spend an hour discussing tax rather than trends. Make monitoring a priority. Produce monthly management accounts and set Key Performance Indicators across the whole Balanced Business Scorecard so you can see performance against every target.
At the review meeting, stick to the big variances and avoid wild goose chases. If you drift off course, take timely, considered action with the fewest side effects.
Where to start
This week, take last year's accounts and work out three numbers: your true gross margin, your breakeven sales figure and your ROCE. Check you have used gross margin, not mark-up, for the first two.
Compare your forecast with breakeven to find your margin of safety. If it is thin, take your best-selling product and ask "why?" five times about its price and cost. Your first improvement is usually there.