Profitability: Your Company’s Return on Investment
To many business owners, achieving a satisfactory level of profitability may seem elusive. With their focus on urgent matters of the day, such as staffing issues, customer concerns and sales figures, it may seem impossible to carve out the time to develop a strategic plan for profitability.
However, there is nothing that is truly more urgent than your company’s profitability. Without profitability, it is difficult for your company to justify its existence. In other words, without profitability, your company – which may well be your largest asset – is delivering no return on investment and has therefore become no more than a place for you to work.
If you follow the model we outline below, you will end up with a better understanding of your company’s current level of profitability as well as a plan to achieve an increased level of profitability over the next two years. The model will likely be easier to employ than you might think, once you understand the factors that affect your profitability equation.
The Four Keys to Profitability
There are four factors that contribute to your organization’s “profitability equation.” These are:
- Variable costs
- Fixed costs
- Net profit
The first factor you must examine and establish a goal for is your company’s revenues. To establish a revenue goal:
- Note the annual revenue of your business over the last three to five years.
- Calculate the rate of growth of your company by comparing revenues year over year.
- Project a realistic revenue goal for two years out based on your company’s previous rates of growth.
Please note that when many people do this exercise, they set a goal they dream of having, which is not always the same as a realistic goal. To test whether your goal is “realistic,” make sure you examine the growth of your business over the last three to five years and apply that same rate of growth to your future calculations, considering other factors such as the projected growth of your industry, the strength of your competitors and the rate of new competitors entering your market.Typically, business owners understand the importance of revenues! However, many think that by increasing revenues, profitability will also increase. This will not happen, however, unless you’ve paid attention to the other three factors that contribute to profitability.
The first profitability goal you need to set is your “variable costs” target. Also known as “cost of goods sold,” variable costs are the expenses tied to delivering a specific product or service. In most cases, these “labor and delivery” costs include expenses related to your operations and sales teams, including commission tied to each sale. In all cases, variable costs are directly related to sales. In other words, when sales go up these costs increase. When sales go down, these costs decrease.
The next profitability goal is your “fixed costs” target. This includes the managerial salaries in your organization – the salaries you need to pay to key managers to run each of the departments. In addition, fixed costs include your administrative and finance department, your sales and marketing budget and basic expenses such as rent, lights and insurance that remain fixed month to month. A good fixed costs goal is approximately 30 percent.
The final profitability goal is your “net profit” target. Your net profit is the amount you have left after all other expenses, (your variable and fixed costs), have been paid. Net profits typically range from 5 to 15 percent in production, manufacturing or construction industries and up to 15 or 25 percent in some service based businesses.
To illustrate this equation, let’s take the example of a construction company that currently generates approximately $4.1 million per year. After reviewing past revenue growth, the owner sees that on average his company has grown at a rate of 20 percent a year. However, knowing that his market is growing a little less rapidly than in the past, he sets a conservative growth goal of 10 percent per year over the next two years, which would result in his company generating nearly $5 million in revenues per year beginning in 2010.
With $5 million as his revenue goal, he then establishes a variable costs goal of 60 percent, meaning that for every dollar that comes in, $.60 goes to cover expenses tied to production and sales. This leaves 40 percent available. Typically, his fixed costs run at around 30 percent of the business, leaving 10 percent for net profit. For a company that generates $5 million a year, this would yield $500,000 in profit per year for the owner.
The Best Tools to Map Out Your Profitability Plan
Once you have established your profitability goals, your next step is to create a plan to take your business from where it is now to its future state a few years out. Using a simple spreadsheet, the best way to go about this is to project, quarter by quarter over the next few years, your revenues, variable costs, fixed costs and net profit.
The next tool to employ is an organization chart. In fact, you can use your ‘Org Chart’ throughout this exercise. With an org chart in front of you, you can review your Sales, Marketing and Operations areas to help you account for the full extent of your variable costs and you can refer to the Administrative and Managerial sections of your org chart to ensure you include all fixed costs.
Once you have developed a profitability plan spreadsheet and have reviewed your org chart, it’s time to develop a new org chart, one that represents the structure of your business in a few years, including the new positions that will need to exist in order for your company to generate the revenue targets you have set. Once you’ve completed your “future company” org chart, you can compare your future and current business and identify the right next step to bring you toward that future goal.
For example, you may see that you need to hire an additional sales person in order to increase revenues. And, as you’re doing that you will also see that to fulfill the additional orders your salesperson generates, you will need to add another person in operations. If you plan to hire both individuals within the next six months, you can add the projected revenues of the sales person and the costs of compensating the sales and operations new hires to your variable costs two quarters from now. In addition, you will need to consider what fixed costs you will need to incur to support these two people, including potentially expanded office space, office supplies and increased HR and administrative support.
One of the key reasons that managing profitability is so important is that it allows you to control the balancing act that needs to occur between sales and marketing and production. Using an org chart and profitability plan as your guides, you can predict and anticipate changes in staffing you’ll need to make a smooth transition toward a more efficient and profitable organization.
How Do You Achieve Your Profit Goals?
Once you’ve established your profitability goals, you may see a disparity between your future goals and the current state of your business. After running the numbers, if you are unhappy with your net profit, there are three steps you can take to change it. You can:
- Decrease your fixed costs. You may want to re-examine your infrastructure costs, such as your lease or phone system, and negotiate a better deal. Or, you may decide to outsource some HR and administrative functions if you have options that would deliver greater efficiency and reduced cost.
- Deliver the product or service more efficiently, cutting variable costs. You can do this by reviewing the processes you have in place for producing and fulfilling sales and re-developing those processes that are the most expensive and least productive or efficient. Additionally, you could look at which products are the most expensive to produce and consider discontinuing these, and instead focusing marketing, sales and production efforts on those products or services that have the greatest margin.
- Raise prices to increase Margins or Lower prices to increase Sales. When was the last time you raised your prices? Studies show that many businesses fail to review their pricing model year after year after year. There are pricing models to help you determine the impact of a price hike. In other words, you may make more money on each sale, but you will make fewer sales. This can be a good thing if done well – you’re making more money and doing less work. On the other hand, you can increase prices too much and lose too much market share. Sometimes just a small increase in your price book, 2 – 5 percent can have a significant impact on the bottom line.