Sometimes in business consulting you encounter the client who says, "I can't understand it! We're working our tails off around here, but nothing is hitting the bottom line!"
When asked what has changed during the past year, the response might be, "We had a competitor open down the road. We reduced our prices to compete. Our sales are great, but we're not making any money."
This business made the common error of misunderstanding whether sales or profitability drives a business. For a product-oriented business, the gross margin (gross profit per sales dollar) must be examined. For a service-oriented business, you must examine the income per labor hour. Other industries have their own transaction profitability measurements.
For example, Companies A and B both sell the same "widget." They both have the same operating costs. Company A has a gross margin of 20%, Company B has a gross margin or 10%.
|Gross margin %
|Net income (loss)
Company B is selling itself into bankruptcy!
Notice that Company B must earn twice the sales of Company A in order to have the same gross profit. In order to make and process those sales, Company B will probably incur higher operating costs than Company A.
It's critically important for the management of a business to understand the profitability of its sales and its cost structure. What costs are required to produce the sales? What is the cost of processing an order?
Many businesses are using activity-based costing techniques to better understand these costs.
Years ago in San Jose we had a pie parlor, Bumbleberry, that was enormously popular, but went bankrupt. When I asked the founder what happened, he said, "I should have had you accountants come in early in the game. It turned out we were losing 50 cents for every pie!"
When we get in a "panic" mentality, such as responding to competitive pressures, we sometimes jump to the knee-jerk response of reducing prices. Instead, we should be thinking about how to build the value of our product or service to charge premium prices! This can involve becoming a specialist for a certain market. For example, one marketer said that you could charge about $89 for a "generic" time management program. The fee for a practically-identical time management program for doctors or chiropractors would be $250. By focusing on a narrower target, it may also be easier to get a response to your program, reducing your marketing costs.
Many times, we're more sensitive about our prices than our customers are. There was a baker who made fabulous chocolate eclairs. His accountant recommended that he raise the prices of the eclairs from 99¢ to $1.50. The baker said, "I'll lose all my customers!" But the accountant insisted that the baker at least test raising the price for a day to see what would happen. The next Monday, the baker displayed the eclairs with the new price. A customer asked, "Charlie, weren't those eclairs 99¢ last week?" "Hmm, well, yes." "Well, it's about time, Charlie. They're the best eclairs in the whole world!"
Fry's Electronics has an interesting strategy to increase the profitability of its sales. They advertise well-known brand-name products at rock-bottom prices. When the customer comes in the store, a Fry's salesperson points out an alternative product that performs just as well at a lower price. The customer is happy to get the job done at a reduced investment and Fry's makes a higher gross profit on the substituted product. (Of course, customers are welcome to buy the "name brand" if they want to.) Of course, Fry's guarantees the customer's satisfaction with the purchase.
If you can't make adjustments to result in your business generating a profit, stop the blood-letting. It's time to close the doors and seek another business where you can earn decent returns.
Would you like support in improving the profitability of your business? Call Mike Gray for an appointment at (408)918-3161.
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