Without a doubt, this is a common question that many business owners ask themselves.
There are many reasons for low profits or lost opportunities when it comes to making a profit and there are a numbers of ways to improve this situation.
Many business owners tend to focus solely on more sales to drive profits and believe if they do that well, the rest will take care of itself. In fact they could achieve a better profit result with less sales, through better efficiencies and controls within their business operations and by reviewing their pricing strategy.
This leads me to my focus in this article on two ways to improve your profit margins:
(1) Reducing costs through creating efficiencies, and
(2) Applying a “Margin” pricing policy
Reducing costs through creating efficiencies
Low profitability could be a reflection of the levels of efficiency and controls within your business. It is possible your profit margins are being eroded through inadequate management controls of your business processes.
Inefficiencies exist in all businesses and could prove to be costly. Reducing theinefficiencies is an opportunity to improve your profit levels. In business we should always be looking for ways to improve what we do and look for better efficiency levels and, at the same time, have an awareness around what impacts our margins and how to improve profitability.
For most small businesses, the easiest way to increase profitability is to reduce direct costs and improve profitability at the Gross Profit level.
Firstly, identify the steps you can take to minimise your direct costs, such as negotiating lower prices with your suppliers. Many businesses tend to stick to the same supplier year after year, so this is an area where some good research may be able to identify a lower priced supplier, or perhaps a closer supplier which may also reduce direct freight costs. Another key area to explore is labour costs. Can your processes be more finely honed to improve productivity? This potentially means you can produce more for the same cost or that you can reduce costs by getting rid of excess capacity.
Secondly, look at your operating expenses. While this is an area often closely watched it can be easy for inefficiencies to creep in unnoticed. Are we monitoring whether that marketing expense is generating an acceptable return; or whether the space we are renting could be more productive; and whether our vehicles are becoming more costly to maintain? Another common oversight with operating expenses is the “creepers”; that is, those costs that increase gradually over time due to inefficiencies creeping into work practices. This could be a simple as regular wastage of a low cost commodity, or convenience outweighing cost effective practices.
Of course there is a limit on reducing costs, especially when your business is operating efficiently. When this is case, turn your focus to other areas within your business in your pursuit of improving your profitability.
Applying a “Margin” pricing strategy
Pricing your product or service is one of the most important business decisions you make, and depending on the pricing model you use, the impact on your bottom line can be varying and significant.
Notwithstanding the importance of comparing your price and quality to your competitors and your customer’s perception of value for your product or service, the focus here is on pricing to achieve a specific level of gross profit margin and maximising your gross profit while remaining competitive.
More specifically my purpose here is to raise awareness around the difference between pricing to Mark-up vs Margin. A clear understanding and application of the two within our pricing strategy can have a dramatic impact on our bottom line. It could effectively mean the difference between you making a profit or a loss at the end of the financial year.
Mark-up and Margin are terms that are commonly used in business. They are also commonly misused and misunderstood.
Is there a difference? Absolutely!!
‘Mark-up’ is based on cost and is the difference between the actual cost and the selling price; whereas ‘Margin’ is based on revenue and is the difference between the selling price and the profit.
Though mark-up is the more common method used to set prices, it can provide a distorted perception of the profitability of the transaction. Many mistakenly believe that if a product or service is marked-up, say by 26%, the result will be a 26% gross margin on the income statement. However, a 26% mark-up rate produces a gross margin of only 20%.
If a product costs $100, the selling price with a 26% ‘mark-up’ would be $126
ie. $100 x 1.26 = $126
To calculate our actual margin on this sale, we first work out our gross profit:
Sales Price – Cost of Goods Sold (‘COGS’) = Gross Profit
$126 – $100 = $26
We can now calculate the actual margin:
Gross Profit/Sale Price = Gross Margin
$26/$126 = 0.20 or 20%
Not quite the margin we were looking for. If we’re expecting to achieve a 26% margin on our sales and we ‘mark-up’ by 26%, we would effectively miss out on 6% of profit on each sale. Meaning that if our annual turnover/revenue is say $3,000,000 the 6% shortfall represents a difference of $180,000 pa to our bottom line.
This may be where some of our profits have gone.
So, how do we determine the selling price given a desired gross margin?
How to calculate Gross Margin
If Sales Price = $100% and
Gross Margin = 26%
COGS should therefore = 74% or 0.74
Gross Margin calculation:
Sales Price = Product Cost/COGS%
Sales Price = $100/0.74 or 74% = $135
Sales Price – Cost of Goods Sold (‘COGS’) = Gross Profit
$135 – $100 = $35
Gross Profit/Sales = Gross Margin
$35/$135 = 0.26 or 26%
The key massage here is that by improving efficiencies we can reduce both our direct and operating costs, and by recognising how your pricing strategy impacts your bottom line we can gain a greater understanding of where some of your potential profits may be going.