Understanding Profitability Relationships in Your Enterprise

20th Sep 2019
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Not having an accurate Cost Analysis in your business will result in Profits of unknown quantity and quality, often resulting in a Loss. Why do some companies who are profitable still fail? A company’s profits aren’t always in the form of Cash, such as Accounts Receivable, which may be currently uncollectable. Solely focusing on Net Income can be a big mistake, unless the variable contingent to net income are considered. It is very significant that a business establishes and tracks certain benchmarks in its Business Plan from which its performance can be easily tracked and measured. As Business Plan Consultant I have seen many a company falter due to inadequate profit planning- often resulting in Business Turnaround Services.


Understanding Profit Relationships and Profit Components


Net Income (Profit) = Revenue (Income) minus Expenses (Costs)


Revenue comes in the form of Cash and Accounts Receivable.

There are Two Types of Expenses: Fixed and Variable


Fixed Expenses: incur periodically, regardless of operational effect and include items such as Rent, Insurance and Depreciation.


Variable Expenses: Vary according to the level of Operations. This includes items such as Product Labor and Material, Sales Promotion and Cost of Delivery.


Types of Profit Expressions:

Gross Income = Net Sales minus Cost of Goods Sold (COGS)

Operating Profit = Gross Margin

Net Income Before Tax

Net Income After Tax


All of these different expressions of Profitability clearly show a relationship between a company’s Revenues and Expenses. Declining Profit Margin should be the sign to search for a cause, which could include: expenses going up, a discounting or pricing error, or a change in the company’s operations.


Planning for Profits


Important Fundamentals:


Liquidity provides maximum flexibility.

Income Statement is viewed in relation to the Balance Sheet and the Cash Flow Statement.

Managed, under control Growth leads to Planned Growth.

A Short and Long Range Business Plan which has clearly incorporate relationships between Product Development, Market Planning, Strategic Planning and Financial Management.


Profit Planning Steps:


Step 1: Profit Goal

A target value based on the realistic, developed results of your Company’s Strategic Plan.


Step 2: Planned Sales Volume required to make the Profit Goal.


Utilize Operating and Sales Budget Forecasts


The Forecasts influence decisions on Materials Purchasing, Production Schedules, Financial Resource Acquisition, Plant and Equipment Procurement, Personnel Enumeration, along with Employment and Inventory Planning.


Forecasts derived from well developed, realistic determinations of Market Conditions, Market Trends, Industry Trends, Competitive Analysis, Competitive Edge, Market Segmentation, Promotion Strategies, Pricing Strategies, Distribution, Inflation and so forth.


Sales Volume Forecasts which are realizable and accurate come from the previously prescribed development relationships between the Product Development, Marketing Plan and Strategic Plan. Picking arbitrary numbers for steps 1 and 2 will result in faulty Sales Forecasts, tainting the process from the beginning.


Step 3: Expenses Estimation for the Planned Sales Volume

Be sure to use the previous years figures if you are an existing business. If you are a start up, it is smart to analyze similar type companies in your industry and use the published research to establish realistic estimated Expenses.


Adjust Expense Projections based on:


Change in Economic Conditions


Ratio of Expenses to Sales Level Change


Production Methods Improvements and Efficiencies


Reasonable salary levels


Materials to produce your goods


Labor to produce your products


Establish a Cost of Goods and liken it to the industry average for accuracy.


Figure in expenses which vary directly with changes in Volume.


Step 4: Estimated Profit


Estimated / Projected Sales Income minus Expected Expenses


Step 5: Compare your Estimated Profit with your Profit Goal (step 1)


If there is a wide discrepancy between estimated profits and your profit goal, continue with the subsequent steps.


Step 6: Determine Alternatives to Improve Profits


Change Planned Sales Income:


Increase Sales Promotion

Improve Product Quality

Improve Access to Product’s Availability

Alternative Product Uses

Analyze Unit Pricing Strategy to determine Best Pricing Policy for your defined Target Markets

Better Service

More Product dependableness

More Integrity in your Sales Process

Better Updating / Upgrading Strategy

Better After-Market Sales Strategy


Decrease Planned Expenses:

Better Control Systems for Product Development

Minimize Losses

Increased Productivity of People & Machines

Product Re-Design, Re-Branding, Re-Packaging

Product Improvements

Cost diminution Analysis and the resulting integrated strategy

Better Budgeting Control Mechanisms


Reduce Unit Costs:

Add other products in the mix to offset costs

Using idle capacity and assets innovatively

Make certain parts internally if more efficient than purchasing from Vendors

Kaizen Costing: Advance Cost Targets in all aspects of Product Design, Development and Production. Each Company Department and Cost Center sets specific Cost Reduction Plans for each quarter.


Subcontract Certain Work and Outsource


Step 7: Determine how Expenses vary with Sales Volume Changes

Experiment with Expense levels in selling fewer or more units with the information obtained in Step 3, understanding the relationship of Fixed and Variable Expenses to find the optimal mix of Products and the Unit Sales of those Products.


Beware:


Analyze Limited changes in Sales Volume as High Sales Volumes are costly and expend a lot of effort and Low Sales Volumes results in extra costs due to idle capacity, lack of volume discounts, underutilized highly trained and expensive labor force, and so on.


Changing conditions: Economic shifts, Inflation, Deflation, Customer Shifts, Competitive Products, Market Shifts and other Factors causing changes in Unit Costs.


Step 8: Understand how Profits vary with Sales Volume Changes

Use different Sales Volumes to determine the resulting Break Even Point and the Profitability Vector.


Step 9: Analyze Profit Alternatives

Using the information generated in Steps 6, 7 and 8 consider profit increasing alternatives, such as:


Sales Price Changes


Change Advertising / Promotion Strategy


Reduce Variable Costs


Increase / Decrease Quality of Products


Find the right mix of Products


Eliminate Low-Margin Products


Bundle High Margin Spare Parts with New Equipment


Step 10: Finalize the Strategic Plan and Implement

Measure the Strategic Plan’s implementation over time to keep track of your Company’s resulting Pre-Tax Return on Equity and Pre-Tax Profit Margin.


Implement Tax Savings Strategies to retain more Earnings for future Opportunities and Expansion.


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