What is Profit and what is Profitability?
Before we can look at how to improve profitability, we first need to understand what profits and ‘profitability’ are.
Profit is the amount of money your business makes over a period of time, less the expenses for that same period. For tax reasons, it is calculated on an annual basis, usually from April one year to March the following year. Profit can be understood using the following formula:
In other words, your profit is what you have left over after subtracting all your expenses from what you earn from sales. This means that there are two basic ways to increase profits: you can increase sales revenue or decrease costs. To increase sales revenue, you can:
- increase product prices, and / or
- increase quantity sold.
An increase in product prices often (but not always) leads to a decrease in the quantity sold. That is, when you increase your prices, sooner or later, some customers will stop buying from you. This means you can only increase profits through increasing prices if the increased revenue per sale offsets any decrease in quantity sold.
The term profitability refers to the amount of profit you get compared to the amount of sales you make, or compared to the size of the business. Profitability is not the same as profits. One of the main ways to increase business profits is to sell more, whereas improving profitability means making more profit from the resources you have and sales you make – you don’t have to sell more to be more profitable.
How is my Profit and Loss Statement Useful?
The Profit and Loss Statement
The Profit and Loss Statement is one of the most important tools a business owner has. You can, and should, use the information within it when working out how to improve your profitability. The profit and loss statement is also called the ‘Income Statement’ or the ‘Statement of Financial Performance’. Although it can be prepared for any period of time (a year, a month, or even a week), for tax reasons, a business needs to prepare one for each financial year.
A profit and loss statement shows:
- The total amount of money you have made during the year,
- The expenses involved in making that money, and
- The profit your business has made.
Components of the Profit and Loss Statement
The profit and loss statement contains the following components:
- Revenue (income). This is the money your business earns. Usually this is from selling products and services, but it can also include income from things like investments and renting out assets.
- Cost of Goods Sold. This is the money your business paid for the products it sold during the reporting period, as well as any costs directly involved in making products or providing services. It includes all ‘direct costs’ involved in providing a product or service, such as the costs of raw materials, freight, and sales commissions. It may even include the wages paid to employees to make products or provide services. This is called ‘direct labour’. However, most wages and salaries are more often ‘fixed costs’ and are included as expenses instead.
- Gross Profit. This is calculated by subtracting cost of goods sold from revenue. It shows how much money is available to cover the general costs of running your business and to make a profit.
- Expenses. These are the other costs your business has, in addition to the cost of goods sold. The amount of these costs is not directly linked to the amount of sales you make – for example, you will pay the same amount for your mobile phone data plan, even if your sales increase. They are therefore called ‘indirect costs’. Examples include overheads such as lease payments and power, administration costs such as accountancy fees and phone bills, selling expenses such as advertising, and financial expenses such as bank fees.
- Net Profit (the bottom line). This is what you have left after taking away all costs from all income. It is calculated by subtracting expenses from gross profit. You’ll pay tax on this income – the profit you get to keep after all the taxes are paid is called ‘net profit after tax’.
The process of calculating profit and loss is shown in the following figure.
Profit and Loss Forecasts
You can also prepare a forecast of a Profit and Loss Statement for the upcoming year to estimate how much profit or loss you think your business will make over this time. Forecasts are particularly useful when you are intending to grow your business or make changes to it, as these will help you to work out how many extra sales you need to make to cover the costs associated with growth. This is all part of a ‘break-even analysis’. Forecasts are also useful for estimating how much you need to save for your tax bill.
The Impact of GST on Profit
Whether or not GST has an impact on your profit depends on whether you are registered for GST and if you are able to claim back the cost of any GST you pay to other businesses. In terms of sales revenues:
- If you’re registered for GST, you must charge 15% GST on all your sales. However, when preparing your profit and loss statement, you do not include this GST in your sales figures. GST is passed on to the IRD – it is not revenue for your business.
- If you’re not registered for GST, you don’t charge any GST on your prices. This means you simply show all money from sales in your profit and loss statement. You don’t have to worry about subtracting GST from your sales income to work out your revenue.
In terms of costs, many (if not all) of the businesses you buy supplies from will be GST registered. This means there will be GST included in the prices you pay them. This will affect your cost of goods sold and the expenses part of your profit and loss statement:
- If you’re registered for GST, you can ‘claim back’ the GST you pay. This means that GST is not an expense for your business. As a result, the cost of goods sold and expenses amounts shown in your profit and loss statement will have GST subtracted.
- If you’re not registered for GST, you will not be able to claim back any GST you pay. This means that GST is an expense for your business. The cost of goods sold and expenses amounts shown in your profit and loss statement will include GST paid. This reduces your profit.
How Should I Use my Profit and Loss Statement?
The Profit and Loss Statement can give you guidance of areas in which you can improve your profits as well as your profitability. It provides you with the figures you need to work out how many products or services you need to sell in order to make the profits you want, and can be used to figure out the impact on profitability of any business decisions you make.
You can get this information by:
- Identifying your largest expenses.
- Comparing the revenue, expenses, and profit amounts on your profit and loss statement from year to year to see which amounts have increased and decreased.
- Calculating ratios such as the gross profit margin and wages to sales ratio, and then comparing these ratios from one year to the next.
- Comparing ratios to industry benchmarks.
- Comparing amounts to your budget for the year.
Prepare a monthly budget for the year and use this to guide your spending. Then, through the year, use your accounting software to produce a profit and loss statement for each month. Compare this with your budget and check to make sure you are not paying for anything your business does not really need. Monitoring actual expenditure on a monthly basis will make it easier to get back on track if your expenses are getting out of control.
Calculating Profitability Ratios
Your gross profit margin and your net profit margin are the main figures you can use to track whether your profitability is improving. You therefore need to know how to use the information on your profit and loss statement to calculate these figures.
- Gross Profit. This shows the difference between total sales and the cost of producing the goods or services you sell. It shows you how much money is available to cover your expenses. Basically, in order to make a profit, you need to ensure your gross profit is higher than your expenses.
Gross Profit Formula
- Gross Profit Margin. This is the amount of gross profit you make as a percentage of the revenue the business makes. Working out this percentage is very useful for several reasons. One is that you can use it to compare to other businesses. If other businesses have a higher gross profit margin, this indicates you are likely to be able to either (or both) lower your cost of goods sold or increase your prices. Looking at your gross profit margin is particularly useful when you are making decisions around what prices to charge and whether or not you can afford to offer customers discounts.
Gross Profit Margin Formula
- Net Profit Margin. This measures the amount of profit made for every sale you make. Increasing profitability is about increasing the net profit margin. Profit is not the same as profitability. It is possible to increase your business profits, but have a lower net profit margin – this happens if you spend a relatively large amount of money in order to increase your sales. Your aim should be to either maintain or increase your net profit margin as you increase your sales.
Net Profit Margin Formula
Use your gross profit margin and your net profit margin as key performance indicators (KPIs).
Calculate these margins for each year you have been in business so far (or for the time you have been operating). Then set a target for each for current or upcoming year. Every month, monitor your progress towards achieving your targets.
There are many other ratios you can calculate from a profit and loss statement which you can use to monitor your profitability. However, for some of these ratios, the resulting information is very similar to that already given by the gross profit margin and net profit margin. It can therefore be a good idea to simply focus on a couple of key margins.
In any case, some ratios you may find useful include:
- Expenses to Sales Ratio, calculated as expenses divided by sales (x 100). If your ratio is increasing over time, your expenses may be getting out of control. If your advertising costs have increased during this time, perhaps your advertising costs more than the sales it generates.
- Wages to Sales Ratio, calculated as total wages divided by sales (x 100). This shows you the percentage of revenue taken up by wages. If it is very high, it shows that a large percentage of revenue is taken up by wages: you might have to think about lowering your wage costs. However, you need to compare this figure to what is normal in your industry as some industries are naturally labour intensive. Wood for a wood carving business is generally quite cheap, so most of the cost of making a wooden sculpture comes from paying the carver’s wages.
Comparing your ratios and margins to industry benchmarks will help you identify where you need to make changes. For example, if your gross profit margin is lower than others in the industry, but your expenses to sales ratio looks good, this indicates you need to focus on reducing your cost of sales. Research to find out whether there are cheaper supplies available or try to negotiate a better deal with your current suppliers.
Some industry benchmarks can be found on the IRD website.
The Difference between Cashflow and Profit
Cashflow and Profit
Profit is the amount of money your business makes over a set time, usually one year, less the expenses for the same period. It is measured using a Profit and Loss Statement. Cashflow is a different thing. It is possible to have a really good profit but no money in the bank. Four reasons for this are:
1. Cashflow is about when money is received
Cashflow looks at when money comes in and out of your business over a period of time. Cash flows into the business from sales, and out of the business as it pays suppliers, wages, and so on. The idea behind a healthy cashflow is to always have enough money to cover your bills. It is about having enough money to keep the business going from day to day, week to week, and month to month.
In comparison, profit looks at the total amount of sales revenue for the year, less the total cost of goods sold and the total expenses. It does not matter when the sales or the expenses actually happen.
Example 1: Timing of Cash Received
Consider the example of a software business which works all year to develop a complicated product for a customer. It may be agreed that the customer will pay them $1 million once the product is finished and handed over. If the total cost of goods sold and expenses are $600,000, they will make a profit of $400,000. However, the business will need to figure out where they will get the cash to be able to pay its employees while they are making the product. If there is not already $400,000 in the bank, they will have a cashflow problem.
Example 2: Timing of Expenses Paid
At the end of the year, a business received a bill from a supplier for $1,000 for work they had carried out. This $1,000 would be counted as an expense for the year, even if the business had not yet paid the bill. In this case, there is money still in the bank, but the profit is lower.
2. Not all cash flows are ‘expenses’
There are a lot of things your business may have to spend money on. For example, you might need to pay courier costs and wages, buy inventory to sell, and pay to get a website designed. If you are a sole trader or partner, you may even need to take drawings out of the business for personal use, and if you have a business loan, you will need to make payments on this. All of this will take cash out of your bank account, affecting your cashflow. However, not all of these items are considered to be ‘expenses’.
Some reasons for this are:
- Inventory is only counted as an expense when it is sold. In the meantime, the amount of inventory sitting in your shop or warehouse is counted as an ‘asset’ to the business.
- Items a business buys which cost $500 or more and have a useful life of more than a year are assets, not expenses. Common examples of assets are websites, furniture, and computers.
- Drawings are not counted as a business expense. This means the business’s profit is likely to be higher than the cash left in the bank. In comparison, if someone is an employee of their business, their wages are counted as an expense.
- A loan is not an expense. Instead, it is a ‘liability’ (debt) which you are paying off.
3. Not all expenses affect cashflow
Sometimes expenses do not require you to make a payment. The most common examples for small businesses include depreciation and bad debts.
Depreciation refers to spreading the cost of buying an asset over the years it is expected to be of use in a business. In other words, depreciation involves treating part of the cost of an asset as an expense each year until the asset is no longer useful. Any business assets which cost $500 or more and have a useful life of more than a year are depreciated. A bad debt is when you ‘write off’ money owed to you from customers.
If a business pays $2,000 for a piece of equipment which has an expected useful life of two years, $1,000 may be ‘expensed’ each year. This means that there will be an expense of $1,000 shown in the second year, even though the equipment was paid for in the first year.
Example: Bad Debts
If you do work for a customer and send them a bill of $800, that $800 would be included in your profit. However, if after a period of time it becomes clear that you are not likely to receive payment from the customer, this $800 needs to be ‘written off’. It is counted as an expense, even though no money will come out of your bank account.
4. Cashflow includes GST
If you are registered for GST, your Profit and Loss Statement will not show any GST at all. However, GST will flow into and out of your bank account. At the end of the year, you may have GST owing which you have not yet paid, meaning there is GST sitting in your bank account, but not in your profit figure.
You need to consider both your cashflow and profitability when making business decisions. Some options for improving your profitability may negatively affect your cashflow in the short term, and vice versa. For example, if you decide to invest in new equipment or a marketing campaign to increase your sales, make sure you will have enough cash in the bank to pay for this and keep operating in the meantime!
Understanding Your Costs
The costs involved in running a business can be put into two groups: fixed costs and variable costs.
- Fixed costs are costs that do not change depending on how many sales you make. They are things like ‘overhead’ costs such as rent, insurance, power, internet, and wages. They also include non-cash expenses such as depreciation on assets the business has purchased.
- Variable costs change depending on how many sales you make. Variable costs could include the price at which products or raw materials are purchased from suppliers, the wages of production staff, and freight costs. For example, if a small business which produces skincare products receives a large order from a customer, its costs will increase as it will need to buy ingredients to make those products.
It can be difficult to decide if a cost is a fixed cost or variable cost due to the fact a cost does change, but not all the time, and usually only when sales increase by a large amount. The wages you pay staff may be an example of this. Some staff (such as the owner) may work in the business all the time and receive the same salary regardless of how much sales are made. However, if sales increase a lot, or you intend to grow the business, you may need to take on another employee.
As a general guide, it is best to count wages and salaries as fixed costs, unless they are directly related to changes in sales. For instance, if you only need to pay someone wages to do a task if you make a sale, count it as a variable cost. However, if that person will be paid regardless of how many sales are made (if any at all), count wages as a fixed cost.
Costs and Profit
Profit can be increased by lowering fixed costs and / or variable costs. For example, you could find cheaper premises to rent, or change electricity providers to lower your fixed costs. To lower your variable costs, you could find cheaper suppliers or try to use fewer raw materials for each product made.
However, when it comes to understanding profitability, there are two main points to keep in mind:
- You will need to cover your fixed costs, no matter how many sales you make. The lower your fixed costs, the less risky your business is. By keeping your fixed costs low, it is more likely you will make a profit, even in times when sales are low. This is why it is important you are aware of what your fixed costs are, and to look for ways to reduce them.
- Your variable costs have an impact on how much profit you make from each sale.You need to be clear about how much each sale is costing you, so you can make good decisions about pricing and discounts. Also, the higher your variable costs are, the less money there will be available to cover your fixed costs.
Make a Profit; Avoid a Loss
You want your business to make a profit, but at the very least you want to avoid it taking a loss. It is worth knowing how many sales you need to make in order for the business to cover all of its costs – this is called ‘breaking even’. Knowing your break-even point lets you know when your business is going to start making a profit.
You can also use a break-even analysis to give guidance on pricing and profit targets. By making a slight change to the break-even formula, you can:
- Work out how many sales you would need to make in order to achieve the amount of profit you are aiming for.
- See what impact changing your prices will have on the quantity of sales you need to make to achieve your desired profit levels.
You will need to decide whether or not the sales quantities from your break-even analysis are realistic for your business. If they aren’t, you will need to consider reducing the price you charge.
At the ‘break-even’ point, a business makes no profit but takes no loss either. Past this point, the business will start to make a profit.
Although a break-even analysis is used to work out how many sales you need to make to break even, you can use the formula to work out how many sales you need to make in order to achieve your target profit levels.
Working Out Your Break-Even Sales Quantity
Two formulae for working out your break-even point are shown below. The first formula calculates the number of items you need to sell per year to break even, and the second formula calculates the value of sales you need to make each year to break even.
The second formula is more useful when you sell a range of products at very different prices. The disadvantage of the second formula is that, if you are new to business, you will need to forecast your gross profit margin before you can use the formula. In comparison, if you are already in business, you can look at your past financial statements or reports from your accounting software to find out your gross profit margin.
The Break-Even Sales Quantity Formula
The Break-Even Sales Value Formula
You can use figures from your Profit and Loss Statement to help use these formulae. However, if your business is quite new or if you plan to make changes to your costs, it is best to forecast your figures. Use the total expenses figure (from your Profit and Loss Statement) as your fixed costs. Do not include the cost of goods sold.
Keep in mind that a business owner working in the business needs to be paid as well. Include your required wage in your costs before you work out how much you need to break even.
If your business is service-based and you charge per hour, it’s simpler to work out the break-even point. This is because you probably won’t have any variable costs if you treat your own wages and any other wages as fixed costs.
For example, if you have total fixed costs of $200,000, and you charge $100 an hour, your break-even number of hours to charge to customers is 2,000 (calculated as $200,000 divided by $100). You would then need to check to make sure it is realistic you could work (and bill to customers) this number of hours per year, given the number of employees you currently have.
Example: Break-Even Analysis
Anahere makes wooden picnic tables and has decided to turn this into a business. She does a break-even analysis to help decide on a sales price. Her fixed costs per year are $70,000. This includes her salary of $50,000 per year and other expenses of $20,000. Each table has a variable cost of $200.
She looks at her competitors’ prices and sees there is quite a range of prices charged. However, the higher priced tables do have nicer designs and require more time to make. Anahere picks several sales prices and calculates how many picnic tables she will need to sell at each price to break even. Putting these into the break-even formula, she works out the quantity of tables she would need to make (and sell) each year. Assuming she will work for 48 weeks per year, Anahere then works this out what this means for weekly production and sales.
Break-Even Sales Quantities for Different Prices
|Price||Formula||Quantity per Year||Quantity per Week|
|= $70,000 ÷ ($500 – $200)
= $70,000 ÷ $300
|= $70,000 ÷ ($750 – $200)
= $70,000 ÷ $550
|= $70,000 ÷ ($1,000 – $200)
= $70,000 ÷ $800
|= $70,000 ÷ ($1,250 – $200)
= $70,000 ÷ $1,050
If Anahere sells her tables for $500 each, she would have to make five tables each week just to break-even. Anahere can make a table in a day, but would struggle to keep up the pace for every working day of the year. She would have no time left to actually sell her tables.
On the other hand, if she sold them for $1,250 each she would only have to make 66 sales each year to break-even. This is only 1.3 per week. Although making this quantity is appealing, trying to sell them is not. Competitors which sell at this price have very well-known brands which Anahere feels would be difficult to compete with.
Anahere decides to make three tables per week. However, instead of selling them at $750 to break even, she sells them at $1,000. Anahere has a high quality product and is confident she can both make, and sell, three tables per week at this price. This will give a profit margin of $250 per table. If she sells the target of 127 per year, this will be a profit of $31,750.
How Much Do You Need to Sell to Meet Your Profit Goal?
What Profit do You Want to Make?
If you have set a goal for how much profit you want to make, you can use a variation of the break-even calculation to work out the number of sales you will need to make to reach your goal. To do this, simply add your profit target to your total fixed costs figure.
Quantity of Sales Needed to Make a Profit Formula
Value of Sales Needed to Make a Profit Formula
You can use either of these formulae to test the impact of possible changes. For example:
- If you are thinking about increasing your profit target, use this figure in the calculation to see how many more sales you will need to make to reach the new target.
- If you are considering bringing on more staff or increasing promotion costs in order to increase sales, add these costs to your total fixed costs. How many sales would you then need to make in order to reach your target profit level?
- See how changing your price (perhaps by offering a discount) will affect your required sales quantities.
Once you have done these calculations, think about what they mean. Is there anything you can do to improve both your overall amount of profit, as well as your profit margins?
Factor to Consider
Be careful to ensure you include the cost of any new strategies into your calculations. For instance, if you are considering increasing the amount of money you spend on promotion in order to achieve the sales quantities shown by your analysis, you will need to add this extra cost to your total fixed costs. This will increase the number of sales you need to make to reach your target profit.
The Cost of a Discount
A common mistake made by new business owners is to offer large discounts in order to attract customers. This is a problem for several reasons:
- Customers may expect the low, discounted prices in future. It is then tempting to continue offering low prices in order to keep customers.
- It may negatively affect the image of your products and services. Some customers associate discounted prices with lower quality products.
- It reduces your profitability and can significantly increase the quantity of products you need to sell to break even.
- It can lead to price wars with competitors – you may feel pressured to increase your discount to match one offered by a competitor.
Discounts mean lower profitability. When you discount your prices, you are discounting your profit margin.
Discounts are generally offered in order to increase sales, and increase profits – but increased sales from discounts do not always result in increased profit. You need to be aware of the increase in sales you need to make up for the discount. This will depend on your gross profit margin.
Let’s say you’re selling a product for $100. The product cost you $60 to produce, leaving you with a gross profit per sale of $40. Also assume that, when the price is $100, you sell 1,000 units per year, giving you sales revenue of $100,000 and cost of goods sold of $60,000. If your expenses are $25,000, you are left with a net profit of $15,000.
This is a gross profit margin of 40% (since $40 ÷ $100 = 0.4).
Now let’s say you offer a 10% discount. This means you sell your products for $90 instead of $100. Your gross profit would then be $30 instead of $40. This means a 10% discount reduced your gross profit per sale by a quarter (25%).
You can then use the following formula to work out what quantity of goods you will need to sell in order to maintain a net profit of $15,000.
Offering a 10% discount means you would need to increase sales from 1,000 to 1,333.33. This is an increase of one third (33%). The key question to ask is “Will a 10% discount actually triple sales?”
Now let’s say your cost of goods sold was only $30 (not $60). When products are sold at $100, this results in a gross profit of $70 (a gross profit margin of 70%). If you follow the same steps as shown above, you would find that the 10% discount would require you to increase sales from 1,000 to 1,167. This is only an increase of 16.7% instead of 33%. The higher gross profit margin of 70% compared to 40% reduced the required increase in the quantity of sales by a half.
The lower your gross profit margin, the larger the required increase in sale in order to maintain your profit levels. Try to look for other ways to increase sales – consider adding value instead of reducing prices.
When Should You Use Discounting?
Offering a discount is not always a bad thing. As long as it increases your profit levels, it can be a good short-term strategy to help move stock or improve cashflow. In some businesses, especially fashion-related businesses, you may need to discount old season stock in order to sell it at all. Holding on to it will only tie up your cashflow and restrict you from being able to buy more stock on which you could make a profit.
If it is normal practice to sell on credit in your industry, and also reasonably common for customers to be slow payers, it may be a good idea to offer a small discount a prompt payment. However, try to build this into your pricing in the first instance. That is, work out your profits and pricing based on the discounted price, then set your regular price a bit higher to allow for the discount.
Offering discounts for buying in large quantities can also be beneficial. In the example shown, a 10% discount for a business which had a gross profit margin of 40% resulted in the business needing to triple sales in order to maintain profit levels. In this case, the business could offer a 10% discount for customers who purchase three or more products (if it is normal for a customer to only purchase one). In other words, instead of offering the 10% discount and hoping for sales to triple, you would be only offering the 10% discount if sales actually did triple. Common mistakes are to:
- Offer people you know a discount.
- Offer discounts to customers who would have been happy to buy from you at the full price.
- Use discounting frequently – customers will come to expect a discount and will not buy until you offer another one.
- Discount products without monitoring the impact on profits.
Increasing your prices may seem to be an easy way to increase profitability and earn higher profits. In some cases this is true! Although increasing prices does give a higher profit margin for each item sold, it might not increase profits – a higher price may mean fewer products sold, and lower sales revenue.
There are numerous pricing strategies a business can follow, and the strategy you follow will impact on your profit margins. It will also affect the quantities of items you would need to sell to make the profits you would like. Since you need to always ensure that any price you charge will cover costs, when setting your prices, it’s a good idea to start with understanding your costs.
Remember that the cost is the amount you pay to produce a product or service (or buy it from a supplier, distributor, or manufacturer). The price is the amount you want your customers to pay for that product or service. The difference between the total cost of providing a product or service and its price is (hopefully) the profit you’ll make.
However, there are other things to think about, such as how much your competition is charging and how much customers are willing to pay. If you base your prices just on covering costs and earning a certain amount of profit, you might end up charging too much or too little. When your prices are high enough to cover costs and make you a reasonable profit, yet are attractive to customers, you’re on the right track.
There are many pricing strategies you can use in your business. The below list shows some of the options and includes notes regarding the impact on profitability.
Work out the cost to deliver the product / service, then add a margin to cover fixed costs and profits (a mark-up). This helps ensure you make a profit, but be careful to also check whether customers are willing to pay the resulting price.
Set the price based on what your competitors are charging. This could mean:
- Setting a higher price, which means you’ll need to differentiate your product, so it is seen as offering more value.
- Setting a similar price, which helps avoid price wars but still means you’ll need to differentiate your product so customers will choose you instead of competitors. This is also called ‘going-rate pricing’. Also check that you can make a profit from this price – your competitors may be able offer this price only because they have lower costs than you.
- Setting a lower price. This is risky – aiming to always have the lowest prices can lead to price wars and making losses instead of profits.
Recommended Retail Pricing:
Sell the product for the price set by the manufacturer or supplier. Using this strategy can be used to avoid price wars, but ensure your fixed costs are low enough for you to maintain a profit.
Change the price of a product depending on the location or point-of-sale. For example, offering a lower price on an online auction website than in store. Variable pricing can also be based on the day of the week. Depending on your rationale for the difference in prices, this could have a positive impact on profitability. For instance, a tradesperson could charge more for weekend work as customers who have emergencies after-hours are willing to pay extra.
New Product Pricing:
Set the price of new product high to take advantage of the lack of competition. Prices are then lowered over time once competitors begin offering similar products. The higher initial prices have a positive impact on profitability per sale – just be careful that it does not result in reduced profits through low sales quantities.
Choose prices based on how they are perceived by customers. Some examples of strategies which may increase profitability include:
- Setting a price just below a ‘round’ number (e.g. $29.95 instead of $30). This is because this is psychologically a lot less than $30 in the minds of customers. This can even work if you are increasing the price (e.g. $29.95 instead of $28.75) – many customers are unlikely to see any real difference in these two prices, even though one is $1.20 more than the other.
- Setting a high price for a product because it gives the impression that the product is of a high quality.
- Introducing a ‘premium’ version of a product for a higher price — this can work in two ways. If the ‘premium’ version is seen as being of higher quality, customers will compare this to the standard version and decide the premium version is worth paying more for. On the other hand, it is also possible to create a ‘premium’ version with additional features customers don’t care about – in this case, customers will probably see the standard version as being better value, and be more likely to buy that instead. If you follow this strategy you need to ensure the version you want to sell more of has a high enough profit margin to provide the profits you want.
- Splitting the price of an expensive product – that is, telling the customer something costs $3.33 per day rather than $100 per month.
Sell a basic product at a reasonably low price, but then make money off high priced ‘add-ons’ which customers are likely to want.
One way to increase profitability per sale is to simply increase prices. This can be risky – customers can react badly to price increases, and your sales volumes may significantly drop. However, the impact on sales may not be as bad as you would think, and a price increase may actually be necessary.
A common mistake is to not review and increase prices when the overall costs in the industry are increasing. If you have no control over increasing costs, passing these on to customers may be the best option. Keep an eye on what your competitors are doing. If they are also affected by the same costs, they may be increasing their prices too.
Example: Increasing Prices
Assume you’re selling a product for $100 which cost you $60 to produce. You’re making sales of 1,000 units per year, so with expenses of $25,000, your net profit is $15,000. Consider the impact of increasing prices by 10%. The new price would then be $110.
You can use the following formula to work out what quantity of goods you will need to sell in order to maintain a net profit of $15,000.
Increasing prices by 10% would mean you can afford to reduce sales quantities by up to 200 products (from 1,000 down to 800) before your profits are reduced. This is a decrease of 20% (calculated as the reduction of 200 products divided by the original quantity of 1,000).
In this case, you would then need to work out how likely it is you will still be able to make at least 800 sales with the higher price.
Before you decide to increase your prices, remember to do research on what your competitors are charging and what your customers will be willing to pay.
After deciding to raise your prices, the hard part is going to be telling your customers about the increase. You could just increase the price and not tell anyone – you’d be surprised how often a price increase goes unnoticed. But if you have regular customers, it is best to be upfront about price increases. The chances are your customers will understand, especially if your customers are businesses. After all, they are likely to have had to raise prices themselves!
Give customers warning in advance, rather than surprising them with an overnight increase. If you are worried about the impact on sales quantities, also consider combining an increase in prices with a way of offering extra value to customers (at little cost to you).
Making More Money
It is likely that for the first year of operations your business will not be making much profit. In fact, you might not be making any profit at all! If you started your business (as opposed to buying an existing one), you will be facing the task of building up a customer base and generating sales revenue while trying to cover the basic costs of operating.
However, understanding your costs and how to manage them will save you money down the road and give you a clearer picture of your business’s long-term viability. If the profit for the foreseeable future is less than what it will cost to run your business, your current business strategy is not viable. You must either cut costs, look for ways to increase revenue, or both.
One way to improve profitability is to focusing on your pricing. Here we will focus on reducing costs. Supplies are a major cost for most businesses. Being smarter about supplies and suppliers can help improve both profitability and cashflows.
Depending on what type of business you have, your business may have a large amount of money tied up in inventory. This money is therefore not available for other uses. You should therefore be careful about the amount of inventory you keep and what you purchase. Poor inventory management can have a severe effect on profitability.
- If you order goods you cannot sell, you might be forced to write-off goods. This means increasing your costs without increasing revenues.
- If you buy more goods than you need, again, you might be forced to write them off. Alternatively, you may need to sell them at a large discount (and perhaps at a loss).
If you order too much, you will also have to find somewhere to keep the excess stock while you try to sell it. Space is limited, and if you are paying for storage, this adds even more to costs while providing no increase in revenues. In addition, stored stock can spoil or become damaged, which can cause additional losses.
Also consider that if you order too much of one type of product, or order stock that does not sell well, you are restricting your ability to buy other stock which will sell. This means you are missing out on sales revenues and, once again, reducing your profits.
- Work out the profit margins on each of your products. Try to avoid stocking products which have a low margin, unless the sales volumes more than make up for the low profit per sale.
- Use your past sales data, along with your sales goals to guide you in how much stock your order. If you are expecting your business to grow by about 15% from the previous year, try not to order much more than 15% more stock than last year’s sales.
- Set a limit on the quantity of stock you will purchase before meeting with suppliers. This is especially important if your business is in the fashion industry or your suppliers frequently have new and interesting stock. This will help overcome the temptation to buy everything which looks new and exciting.
- Analyse past sales data to work out which stock moves slowly and then, where possible, avoid ordering these items.
Supplier Relationship Management (SRM)
How you treat your suppliers is vital to the success of your business. Your inventory management depends, in part, on the relationship with your suppliers.
A good relationship with suppliers can have a positive impact on profits for several reasons:
- It can make it easier to get supplies when you need them, thus increasing the sales (and profits) you make.
- It may result in being offered better prices on your purchases, thus increasing your profit margin.
- It may mean you are offered favourable payment terms – this may be a free source of credit.
- Suppliers may reduce your minimum order quantities, and therefore allow you to keep less stock on hand.
- Suppliers may be willing to distribute products direct to your customers, thus avoiding the need to keep much stock on hand and reducing your freight costs.
An ideal situation is where you have little or no stock on hand, and only pay for stock when customers order it. It is more possible to achieve this with online businesses as customers do not come to a physical store where they expect to see stock on shelves. If you have a good relationship with suppliers, you can be confident that they will have the goods you need in stock in order to be able to fill customer sales as they are made.
Good Supplier Relationship Management (SRM) practices are essential to the health of your business. You and your suppliers are essentially business partners – you rely on them for stock or supplies, and they rely on you for income. However, unlike a normal business-customer relationship you and your suppliers have a more ongoing partnership. Clear and timely communication with your suppliers is therefore vital. Also make the effort to send them (for example) Christmas cards and take other opportunities to thank them for their service.
Although price is important, it is only one factor to consider when choosing a supplier. You also need your suppliers to be reliable, stable, and to provide high-quality products on time. Even if you find another supplier with a lower price, think carefully before you switch. Bouncing around between suppliers can make your business look unstable, and might make it less likely for good suppliers to want to do business with you.
Always keep in mind that your suppliers are also in business. They are also trying to get the most value out of what they are providing. Your relationship with your suppliers should be one of mutual benefit. Your suppliers do not owe you special deals, but this does not stop you negotiating on price. Just remember it needs to still be worth it for the supplier—no supplier wants to deal with a customer who won’t allow them to make money too!
Factors to Consider
If you stick with a supplier long enough you may be seen as a valued customer. In such a case they will probably have a lot more tolerance for special deals, changes in orders, and requests for new products.
However, always be aware of your options. Keeping with one supplier does not mean they will automatically offer you the best deal – if they do not recognise you as a valued customer, you may be better off switching suppliers.
More Practical Tips to Improve Profitability
There are many other ways to improve the profitability of your business. Some of these are as follows.
Your business should always be aiming to produce its product or service as efficiently as possible. That is, make more products with a set amount of inputs, or the same number of products, but with less inputs.
Examples of ways to do this include:
- Avoiding the need to pay staff overtime payments at a higher hourly wage rate. Plan work in advance so it can be done during normal working hours.
- Providing training to staff who are slow or unconfident, so they can produce a higher amount of quality work in a shorter period of time.
- Reviewing staffing levels and thinking carefully before employing additional staff – if you only need someone for a certain number of hours per week, do not employ them on a full-time basis.
- Using technology to speed processes up or do tasks cheaper. For example, keeping important files on shared drives or online means staff members can access these immediately and as required, and using accounting software instead of doing tasks like payroll manually.
- Using technology to plan work more efficiently. For example, use GPS technology to see where tradespeople are so you can send the closest person to new jobs which come up during the day (reducing petrol costs and travel time).
- Choosing more efficient equipment.
- Finding ways to reduce waste and employee ‘downtime’. Something as simple as having a water cooler situated close to employees will reduce the time they spend walking to the lunch room to get a drink of water.
You should be constantly on the lookout for inefficiencies to eliminate so that you can make your business more productive. This helps you increase revenues while keeping the same costs, lower costs while keeping the same revenues, or lower costs and increase revenues. New technologies that have the potential to increase efficiency appear on a fairly regular basis, so keep an eye out to see what is available.
Regularly review the processes used to produce your business’s product or service. Look for ways these processes could be streamlined without impacting quality. Employees who are involved in these processes will often have good ideas about what could be changed. It also helps to keep up with the latest news and trends in your industry. You can do this by reading industry publications, attending conferences, or joining industry associations.
Setting clear targets for productivity can be motivating for your staff. If you communicate well, and set the right tone, you can get the team excited about reaching the targets. Consider giving small rewards when targets are exceeded, but ensure the cost of the reward does not offset the benefits of the increased productivity!
A few ideas to reduce costs, and therefore increase productivity, are as follows:
- Reduce your power costs through conservation or by changing providers.
- Avoid unnecessary travel expenses, such as by using video calls rather than visiting clients in person.
- Identify suppliers you can approach for better terms.
- Cut advertising where you cannot measure results (focus on forms of promotion for which you can measure the benefits relative to the costs).
- Encourage a ‘paper-less’ workplace to reduce printing costs.
- Lease (or sub-lease) unused parts of your premises to another business.
- For online businesses, consider using more than one courier – for each customer order received, choose the cheapest courier out of the options you have available.
- Weigh up the cost of owning a business vehicle, against reimbursing yourself for use of your personal vehicle.
If you’re sure your costs can’t be reduced, then re-consider your pricing. You’ll need to convince your target market that your products or services are worth the additional price. This can include making sure marketing is effective and making sure your customer service is up to scratch.
Good cashflow management is essential to any business. Without money in the bank, you may be forced to go without buying the supplies you need to make sales, be late in paying bills, or have no choice but to borrow money to keep operating. All of these scenarios impact on your profits.
If you forecast that you will make a good profit, you are on the right track. However, this does not mean you will actually have cash in the bank. Remember, profit is not the same thing as cash. When you are starting a business, you are likely to have to spend cash on buying the assets you need to make and sell your product or service. For example, if you have a lawn-mowing business, you will probably need to buy a lawnmower. While these purchases take money away from your bank account, only a portion of the cost (the depreciation amount) affects your profit.
If your bank balance is low during the start-up period, it is important to understand the reason for this. If it is a result of cashflow reasons associated with starting a business (e.g. buying assets), this may not be too much of a concern. However, if it is due to low profitability, you should look at your business model to see if there is a way to reduce your costs in relation to your sales revenue.
Although it is common for a new business to not have much cash in the bank, check to make sure this is not due to an unprofitable (and unviable) business model.
Some practical tips for improving cashflow are as follows:
- Reduce the amount of credit you offer customers. As much as possible, require customers to pay at the time a purchase is made. Where this is not practical, use credit checks before extending credit to customers, and require payment within one week. Try to make sure that anyone to whom you give credit has a track record of paying their debts.
- Make debt collection a priority. If you need to offer customers credit, have a process in place for following up on overdue payments and follow this consistently.
- Invoice immediately. If you wait to invoice, you must wait to be paid.
- Set up electronic payments in advance. Look at the terms for payment on the invoices you receive and then set up a payment to occur the night before it is due. This keeps your money in your account for longer.
- Use an electronic calendar to remind you of when payments are set to come out of your account. This could be the calendar function on a smartphone, or the calendar function in Microsoft Outlook, for example. This way you can make sure you have the money in your account when needed (and avoid ‘unarranged overdraft fees’). Get the calendar software to send you reminders before the payments are due.
- Create a cashflow forecast so you can identify any problems in advance and prepare for them (or avoid them).
- Reduce the amount of stock you keep on hand. If you have a retail premises, consider if you can set it out in a different way so it your displays and shelves still look attractive, but you do not have the volume of stock as you usually would.
- You may also choose to lease rather than buy assets. However, weigh up the alternatives carefully. Leasing is more expensive in the long term (and therefore reduces profitability), but frees up cashflow in the short term.
- If you must offer customers credit, and it is difficult to avoid slow payers, consider offering a small prompt payment discount. Remember that discounts negatively affect your profitability. Therefore, if possible, build the cost of the discount into your normal pricing so you can maintain a good profit margin.
Tax and Cashflow
As a small business owner, you are responsible for making sure your business pays its taxes. There are several taxes you are responsible for paying or collecting and forwarding to the IRD.
- Employer Deductions and KiwiSaver Contributions. The amounts you deduct from employee wages for income tax, ACC levies, KiwiSaver, student loan payments, and so on, need to be sent on to the IRD. In addition, you must make KiwiSaver employer contributions if your employees are KiwiSaver members.
- Income Tax. Your business must pay tax on the profit it earns and must make regular payments throughout the year (called provisional tax).
- GST. As a business owner, you are responsible for collecting the GST your customers pay and passing it on to the IRD.
It is important that you pay your tax bills on time. If you get behind on your payments to the IRD, they will charge penalties, and will then charge interest as well! The longer you do not pay, the greater the cost of a missed tax bill. This increases your expenses and decreases profitability.
Using a cashflow forecast can help you plan ahead to make sure you have enough money to cover your tax bills. They are due at regular dates throughout the year so you should be able to plan ahead. It may help for you to increase the frequency with which you make payments. Although registering to pay GST six-monthly is an option for small businesses, consider two-monthly or monthly. The more often you make payment, the less likely you will accidentally spend the money on other areas of your business.
If it is your first year in business, you are not required to pay provisional tax through the year. Instead, you are required to pay your full tax bill after your profit for the first year is calculated. However, depending on how much profit you made in the first year, it is likely you will need to start making provisional tax payments through your second year of business. Paying this at the same time as you need to pay your income tax for the first year of business can be challenging for cashflow.
One option you have available to you is to start making provisional tax payments throughout your first year in business. Although you are not required to do this, the bonus is that you will receive a 6.7% discount on your tax bill (calculated as whichever is lower out of the amount you actually pay, and 105% of the amount of tax which is payable for the year).
Consider using the ‘AIM’ option for paying provisional tax (Accounting Income Method). Under this method, you pay provisional tax based on the profits you are currently making, as shown by your accounting software. This helps match your cashflow with your profits, and therefore reduces cashflow problems. Another benefit is that, as long as you pay the amounts shown to you by your accounting software (and do this on time), no penalties or interest will be charged.
Payments are due for the same period as you are registered for GST. Therefore if you pay GST bi-monthly, every two months you will use your accounting software to show you how much provisional tax to pay. If you make a loss, you can receive a refund instead of waiting for the end of the year.