Understanding Profitability Relationships in Your Enterprise
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
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
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
Increased Productivity of People & Machines
Product Re-Design, Re-Branding, Re-Packaging
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.
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.