By: Doug and Polly White April 19, 2016
A small manufacturer contacted us — an owner who had seen his revenue double in the past year but still wasn’t making any money. To the contrary, he was barely breaking even. When we looked at his operation, we saw that, over the same time period, his costs had also doubled. This shouldn’t have been the case, of course. As a business grows, its costs should increase more slowly than its revenue, so that profit compounds. If you find yourself in a similar situation, we suggest four places to look for your lost profit.
- Product profitability
If you don’t already, you need to understand the gross margin of each item you produce (gross margin = sales price – the cost of goods sold). The cost of goods sold is everything you spend to make your product. At a minimum, this will include materials and labor. You may well find that some of the items you produce have a negative gross margin. You can’t make that up in volume because you’ll be losing money on each unit you sell. And negative gross margins are sometimes justified, if they allow you to sell other products that make lots of money. Razors are the oft-cited example here: You may be willing to lose money selling razors if the result is profitable blade sales.
However, in general, you should not have negative gross margins. If you do, you should either increase the price or find a way to reduce the cost of goods sold. In many businesses, it makes sense to establish a minimum acceptable gross margin. Then, price your products so that you achieve at least this level. For example, if your overhead as a percentage of revenue is 20 percent, establish a minimum acceptable gross margin of 25 percent (gross margin percentage = gross margin ÷ revenue). This means that, at worst, you will cover your overhead and make a 5 percent profit. In the case of our client, he had some products that were not covering their share of the overhead. We set out to help him find ways to improve these gross margins.
- Customer profitability
You also need to understand the profitability of each of your customers. Most often, some customers will pay lower prices than others will, and some customers will cost more to serve than others. These differences drive different levels of profitability. And you may find that some customers are just simply unprofitable. So, take steps to improve the profitability of these relationships: Increase the price you charge these customers, or reduce the costs of serving them. You can do the same analysis of customer profitability that we describe above, for product profitability. You can also set minimum profitability goals in the same way. We’ve done this analysis across a broad range of industries. We have often, but not always, found that large-scale customers are less profitable because they can have the volume to negotiate lower prices. Small-scale customers are frequently less profitable because they are expensive to serve. Midsize customers may be the most profitable to serve.
As revenue grows, overhead should remain relatively constant. Take a look at what happened to your overhead as your business grew. Too often, small business owners let their overhead costs rise with revenue. If that is the case in your situation, cut overhead back to pre-growth levels wherever possible. We understand that some overhead costs may grow with revenue.
For example, if you are sending out more invoices, that effort will likely require more labor hours. However, many overhead costs can be held constant as revenue grows.
- Cost reduction
Does your new higher volume provide opportunities for cost reductions? Since your volume has doubled, you may be able to negotiate material prices. If you are sending out twice the number of invoices, perhaps the process can be automated. Volume growth provides opportunities for cost reduction. Make sure you capture these opportunities.
Overall, we’ve noted, too many small businesses fail to capture the economies of scale that should accrue to them as their volume increases. Following the tips above will allow you to claw back the profit you’ve missed.