By Alka Sood
Senior Business Advisor, BDC
Margin killers are oversights and inefficiencies, throughout your business, that may seem small on their own, but together, can make the difference between a flourishing company and one that struggles to survive.
Two ways of measuring profit
As you can see in the income statement example below, there are two measures of profit.
The first is the gross profit. It reflects the amount of money a company has left over, after accounting for its direct costs to make a product or deliver a service. Direct costs include labour, materials and other expenses that are directly related to producing a product or service. In this example gross margins (which are gross profits as a percentage of sales) are 66% of sales.
The second, net income, is a more comprehensive measure. It takes into account not only your direct costs, but also all your other expenses, including overhead to operate the business, taxes and interest paid on debt. After reflecting overhead costs, the net income margin is only 12% of sales.
You can see there are layers of expenses where margin killers may be lurking. But it’s not only unnecessary expenses that can hurt your bottom line. You may also be failing to collect all the money you should from your customers.
The key to reducing and eliminating profit killers is to be able to dissect your financial statements and highlight the areas where you are losing money and see what strategies you can use to prevent cost and revenue leakage.
With this in mind, let’s look at five margin killers and how to eliminate them.
Pricing that doesn’t reflect your true costs
It’s common for companies to neglect, or low-ball, expenses when setting prices. For example, a landscaping company will charge for worker time spent on a project but fail to include travel time to the site. Or a manufacturer may set prices that don’t adequately cover overhead items such as the cost of running the office, equipment or paying the accountant.
You have to closely examine your direct and overhead costs to make sure they are all reflected in how you calculate your profit margins and pricing. This is even more important during a time of rising inflation. Your suppliers are raising the prices they charge you. You need to ensure your prices reflect this reality.
Are you worried about customers going to a competitor if you raise your prices? You don’t have any choice. You’re in business to make money and that sometimes involves tough choices and difficult conversations. The best solution is to be transparent with your customers and explain what you have to pay to provide them with a product or service. If you’re company isn’t competitive at a fair price, you need to make necessary changes to your business and/or operating model.
Holding onto unprofitable products
Some products are costing you money and you may not even be aware of it. That’s why it’s important to analyze your financial data to break out the profitability of individual products and services. You will likely find you are carrying winners and losers.
Once you have identified unprofitable items you can decide what to do about it.
Could you raise your price for those items?
Should you keep the product because it is a strategic requirement to win other sales?
Is there a better way to produce or offer them?
Or do you have to eliminate them altogether?
Failing to manage customer relationships
It’s a fact of life that some customers require more time and attention than others. And that means they are more expensive for your business. For example, they may be late in delivering a document you need to get started on a job. Or they may ask for changes or add-ons that weren’t included in the contract you signed.
Too often, companies go along with doing extra work without charging for it. On one construction project, we found the company had provided free work on customer changes that equated to 10% of its total revenues earned on the project.
The key to dealing these kind of margin killers is to plan ahead and be vigilant. Stipulate in your contracts how changes and add-ons will be invoiced. Make sure your team always tells you about unanticipated requests before the work is done and then inform the customer what it will cost.
Allowing direct and overhead costs to grow uncontrolled
Growing revenues can often lead to a lack of rigour on expense control. A close look at where your dollars are going may reveal rising costs for such things as new employees, vehicles or advertising and marketing that are not producing a corresponding increase in revenue.
Furthermore to control overheads, we recommend setting budgets for your overhead expenses and then sticking to them. The amount budgeted for each line item should be based on analysis rather than simply using last year’s numbers. A business case should be made for any substantial increase.
To cut expenses, use the 80/20 rule when deciding which ones to attack first. Look at the outlays that represent 80% of your total expenses and work on reducing those. That’s where you will get the most bang for your efforts.
It’s also a good practice to go to the market periodically to see if you can get a better deal on fixed costs, such as insurance, telecommunications services and maintenance contracts.
Failing to use technology
Technology-based solutions are invaluable in the fight to eliminate profit killers. They will help you find where profit is leaking and optimize your operations, customer relations and pricing.
You can use your accounting software to calculate your profit margins, track your expenses and monitor asset turnover, among other key performance indicators.
Manufacturers can use software to monitor how much downtime they are experiencing for factory line changeovers and equipment repairs. Similarly, timesheet tracking software allows you to monitor worker productivity and generate data for invoicing.
Keep a constant watch on your margins
Maintaining healthy profit margins is essential for ensuring your business is earning the money you need to reinvest to stay productive, competitive and growing. That’s how the very best businesses get stronger with every passing year.
Reprinted from The Business Development Bank (BDC) blog. Download the BDC’s eBook, Monitoring Your Business Performance, to learn more about key financial ratios.