First published September 2021
It’s been a turbulent couple of years for business owners, in this blog we reconsider the way you should measure success, and the key metrics to monitor to ensure your business stays viable.
The two key takeaways we want you to take note of are:
1. Gross profit dollar value is the key indicator you need to watch
2. Why having a flush bank account can have hidden issues.
Takeaway One: Gross profit dollar value is the key indicator you need to watch
Sales may be looking good, but with costs increasing across the board, this does not necessarily equal increased profitability.
Gross Profit: Revenue less all direct costs
Net Profit: Gross Profit less all overhead costs
Sales should not be your key financial measure
Wait, but why not?
Your sales may have increased (as you have passed material/freight cost increases onto your customers), but if you have squeezed your margins then you will earn less.
Check out this example below:
Example 1
Looking at this, you can see sales have increased (yahoo!) but your profit has decreased (☹).
Possible Solutions
Options:
A. Do nothing
B. Increase prices slightly to cover some of the costs
C. Increase prices to pass on the increased costs
D. Increase prices to pass on the increased costs and keep your margin
Let’s see the impact of the solutions in Example 2 below.
Example 2
So why shouldn’t we focus on sales or gross profit % as a measure of success?
We can explain using Example 2 above:
Sales Growth as a success measure
Under all options, sales have either remained constant or have increased (yay 😊) but you can see under Option A & B, you have made less money
Gross Profit % as a success measure
If you focus on gross profit %, only option D (increase prices to pass on the increased costs and keep your margin) would remain at 30%
Gross Profit Dollars as a success measure
However, if you focus on gross profit dollars, you are still making the same profit in Option C, even though your gross profit % has reduced from 30% to 17.6%, hence focusing on gross profit dollars is critical in times of inflation
What actions should I take?
1. Consider price increases to reflect increases in direct costs + overheads
Why? As shown above in Example 2, under Option A & Option B, if you don’t pass on all your costs, you have tightened your margins and you will miss out on profit. The impact of this could be devastating for your business as you may not be able to meet your overheads and debt repayments.
Consider the following:
Loyal clients are buying from you due to your quality of service and product not solely price. Loyal customers won’t be scared off by price increases. In today’s environment, they are expected
Many businesses will be increasing prices to stay ahead, those that don’t may not be viable
What if I have fixed-price contracts in place?
This can be tricky, but we recommend going back to your customers, explaining the situation and the impact several fixed-price contracts have on your business to try renegotiating prices. The worst case is that unless you can increase the price of these contracts, you may not be able to cover your bills and the business goes under. Your customers need your business to be successful in order for you to fulfill the contract, so proactively have the conversations.
2. Budgeting for cost increases
Why? You may not want to increase your prices frequently, so you need to predict, budget and forecast for changes/fluctuations in prices, otherwise as mentioned above your margins will tighten and you will miss out on profit. In some cases, it may not be possible to pass on all of your costs as prices increases. In this instance, you may need to push harder with marketing or retargeting past customers, with a goal of a higher volume of sales to achieve the same gross profit dollar value.
Additionally, if your overheads increase, you will need to ensure your gross profit dollar value also increases (Option D above in Example 2) to maintain the same level of profit you’ve previously achieved.
3. Monitor Gross Profit ($) and Net Profit
Things may look a little different this year as you assess your financial targets, but these suggestions will help you ensure you’re still winning even when your costs are increasing.
Keep an eye on your gross profit and net profit lines this year, don’t be afraid to increase your prices if necessary and focus on services/products which give you higher gross profit $$.
If you can achieve increased sales at an increased price level, you’ll be protecting your profit which means you can continue to grow, invest in your people and reinvest in your business.
Takeaway Two: The hidden issues of a flush bank account
Do you monitor your bank account to determine how well your business is doing?
We highlight the risks you face and how you may be getting false hope of a profitable business if your bank balance is your key success measure. You could be suffering serious consequences and making decisions too late – We all know speedy and well-informed decisions are required in this environment.
The key signs you need to be aware of and monitor are:
1. Bank account flush
2. Accounts receivable decreasing
3. Stock levels decreasing
Your sales may be lower than normal, this means the amount you can invoice to clients reduces, reducing your accounts receivable. However, you are likely still receiving cash from historic products/services sold, thus your cash will be increasing.
Additionally, with delivery timeframes reducing, the amount of stock you order/hold may reduce, this means you will be able to keep more cash in your bank account.
Let’s see an example:
Example 4
If your accounts receivable has reduced, your bank account will increase, as you have physically received the cash from past sales. However, you may be making losses each month from current sales.
When accounts receivable stop decreasing (or starts increasing again) you have the potential to run out of cash (see Example 4 above).
What to do?
Ensure you monitor your gross profit and net profit dollars each month to ensure you are still making a profit and keep cash aside for when work returns to ‘normal’ and you need the cash for working capital.
The team at Velocite is experienced in supporting business owners to improve business profitability. If you would like our support don’t hesitate to get in touch!
Or Download our Free Toolkit to begin planning on your own