There are five basic ways in which a firm can have a direct effect on its profitability:
1. Increasing sales volume.
Increasing sales volume may appear to be an easy way of increasing profitability, but this is not necessarily the case.
- Selling more and more is not the key to increased profitability: profit requires sales, but sales does not equal profit.
- If you increase your sales volume, you must at the same time rigorously control costs, prices, capital employed, and your product/service mix. Be sure that none of these four other components of profitability increases disproportionately; if they do, increased sales reduce instead of increase profit.
- Trying to increase your sales by employing an additional sales rep or trading in a bigger geographic area only produces more profit if the extra sales produce at least enough extra profit (not revenue) to cover the extra costs.
- If you cut prices and margins to generate more sales, you need to achieve a considerable increase in sales volume – otherwise total revenue falls while costs remain the same.
- Increases in small volume orders may hinder profitability instead of boosting it because of inherent administrative costs such as invoicing and dispatching.
- If you extend credit in order to encourage more sales, the company will have to bear the costs – with a knock-on effect on profitability
- Selling more of all your existing product/service lines or introducing new ones may increase your sales volume, but be sure you know the contribution each line makes. Selling more of loss-making lines is bad business unless it is necessary in order to raise sales of profit making ones.
In some circumstances you can increase profits by reducing sales. Surveys have shown that a wholly disproportionate amount of cost and effort is sometimes invested to achieve a small amount of sales revenue. It is not uncommon to find that 50 percent of deliveries made account for only 15 percent of sales revenue. Or there’s the 80/20 rule: 20 percent of your clients account for 80 percent of your profits. Consider what would happen if you reduced your sales by a selective 10 percent.
2. Reducing costs and/or ensuring that costs are fully recovered where this has not previously been the case.
Investigate and calculate your true costs in total and for unit sales. You cannot adjust your costs in relation to other parts of your business unless you know what they are. Consider the effects of specific cost reductions carefully – arbitrary reductions may not produce the desired results in the long term. Seek advice from your accountant, your auditors, and your bank manager.
3. Improving the product mix
This means varying the relationships between the volumes of individual products or groups of products sold. Your product/service mix reflects the combinations in which the products or services you provide are sold. The mix is normally derived from a series of historical accidents rather than from careful planning and analysis, and consequently it many not be as profitable as it could be.
Examine each product you sell in terms of the costs attributable to it and the net margin it makes. You may find that the products producing the highest unit gross profit and making the highest percentage contribution to your sales volume also attract a disproportionate amount of your selling costs.
You may find, for example, that you should aim to sell more of A and B, which you have found to be profitable, to supply less of C and D, which are of limited profitability, and to eliminate loss-making E and F from your sales portfolio. Consider the impact this will have on the other four factors – for example, a well-founded change in your product/service mix may lead to reduced volume of sales but increase your profitability.
4. Raising prices selectively or overall.
Raising selling prices is a potential route to increased profitability (or at least to maintaining the current level of profitability when it might otherwise fall), but there are of course pitfalls. Although customers may accept price increases if they are part of a general price adjustment in your business sector (in which case you are likely merely to maintain your overall level of profitability), raising prices in isolation without losing business (and thereby risking reduced profits) requires either a near monopoly, a vast difference between your products and your competitors’, or a carefully thought out and implemented policy and sales strategy.
5. Reducing the capital employed in the business.
Obtaining a good return on capital and reducing the capital tied up in your business normally improve profitability. Identify the categories of capital employed in your business and consider whether the following strategies can apply to any of them:
- Exercising tighter control of credit
- Reducing inventory levels
- Introducing outsourcing or expanding its scope
- Exploiting information and telecommunications technologies more fully
A change in any one of these affects the others. Any change, made or planned, voluntary or involuntary, must therefore be considered in the context of all others; changes made in isolation may not have the expected impact on profitability.
Recommended Readings on How to Improve Profits:
- How to Increase Profit: 4 Simple Steps
- How to Handle the Business Profits of a Home Business?
- How Much Do You Make from Your Business?
- Do’s and Don’ts in Cutting Down Overhead and Business Costs
Excerpted from the book Business: The Ultimate Resourceby Daniel Goleman (Publisher: Basic Books; 1st edition August 16, 2002)
Category: Financial Management