Every business owner wants to make a profit – survival depends on it. However, many struggle to determine if their business is really profitable. Managing profit can be complicated and it is easy to fall into a variety of mistakes that eat your profit away. Let’s look the classic profit mistakes that many people make and the better alternatives that will help you make the profits you need.
Over-relying on your bank balance
Too many business owners rely on judging the profitability of their business based on their bank balance. However, you might be making a loss despite the cash in your bank. This may be because:
• You have not paid your suppliers or other creditors
• You have received advance cash from your customers
• Payroll expenses have not been reflected in the accounts
• You are not paying yourself a reasonable salary
• You haven’t made adjustments for all expenses
Have a conversation with your accountant and go through the above list together with other factors specific to your business.
Not Looking after margins
This is an important indicator to profitability, but it’s often misunderstood by entrepreneurs. The next time you get your accounts, take the direct costs of sales or direct expenses out from the revenue. Then divide that number by the revenue. That is your gross profit margin.
Let’s say your revenue is £1,000 and your materials or direct labour or direct expenses cost you £700. The difference of £300 divided by £1,000 revenue gives you a margin of 30%. This means that for every £1 of sale, you are making 30p in gross profit. This tells you how profitable you are at the gross margin level.
Wrong Calculation of Price
Having ascertained your profit margins of 30%, a common and huge mistake I see is as follows. You go to see a new prospect. You take your costs. Let’s say 1,000. What do you do next? You apply 30% to the costs. You then quote £1,300 for the job. It makes sense, right? Well not quite. If you take your £1,000 costs from the £1300 revenue (price) you get £300. Now divide that by £1,300. You now get 23%. You’ve just lost 7% profit margin without even blinking.
And this mistake will make its way down to the net profit figure causing you to be less profitable year after year.
Worry about increasing prices
People often fear of losing customers if they put up prices. Let’s say you have 20 customers and your price is £1,300 per customer. (£26,000 revenue) If you put prices up by 10%, your new revenue will £28,600. If you lose 10% of your customers (2 customers x 1,300 = £2,600), your revenue will revert to £26,000 but with two fewer customers and less resources needed to service the remaining 18 customers. Depending on how you approach the price increase and how you communicate it, you might be pleasantly surprised that less than 10% of your customers will leave.
Indeed, a study by global consulting firm McKinsey and Co revealed that increasing pricing has a bigger influence over your profits than reducing costs or increasing sales volumes.
But here is what most entrepreneurs do not consider doing: Assessing the power of a mere 1% increase in price, 1% increase in sales, 1% decrease in variable costs and 1% decrease in fixed costs.
Next time you sit down with your accountant, ask him or her to run these numbers and show you the impact it will have on your profits. Would you lose a lot of customers due to a mere 1% increase in price?
Not measuring revenue per employee
If you have staff, a common profit mistake is not measuring revenue per staff or profit per staff. This is simply taking the revenue or profits per year and dividing it by the number of staff. Let’s assume your income is £100,000 and you have four staff. Your revenue per staff is £25,000. Now compare that to the average cost per staff. This simple exercise will help focus your mind on what needs to be done to increase your profit.
Flying without navigation
Peter Drucker (the management guru) is often quoted as saying that “you can’t manage what you can’t measure”. When it comes to profits, the biggest mistake is not knowing the profit numbers that matter in your business. Your gross profit margin, profit per staff, profit per client or project, net profit margin, breakeven number, your monthly costs and your prices are all important numbers to track and focus on. If you currently speak to your accountant once a year only to be told how much tax to pay with no access to your key numbers, then it is unlikely you will be able to improve on your results.
The good news is that with so many online accounting apps on the market, (FreeAgent, QuickBooks and Xero), entrepreneurs should no longer be flying blind in their businesses.
Undercutting – without a plan
The mistake I see here is to look at your competitors’ prices and under cut them in order to win business. Often this is done without a plan (short term low cost strategy or need to set up a no frills division to compete in the market). So, in long run, when you win more business you find yourself not making profits because your costs have gone up and it becomes challenging to raise your prices because you’ve attracted price sensitive customers.
Not separating profits
In his book Profit First, Mike Michalowicz makes a compelling case for opening another bank account and transferring your profits before you make payments to anyone. So, if you’ve worked out that your net profit on every sale is 10%, then a safe way to see and secure those profits is to transfer it straight away to your “profit bank account”. That way you are forced to make do with the remaining 90%.
For a business profit is the air it breathes in order to survive and thrive. If you run a business you must get fully up to speed with your profit, what impacts it and how to avoid unnecessary mistakes that will lower profit. That way you’ll be able to enjoy a positive outcome from all your hard work!
About the author: Jonathan Amponsah CTA FCCA is an award winning chartered accountant and tax adviser who advises entrepreneurs on business and profit improvement. Jonathan is the founder and CEO of The Tax Guys.