This might sound like a strange question, but business success can actually be quite tricky to determine. By way of example, my wife decided to embrace her newfound creative side and manufacture custom jewellery. The pieces were all amazing and she couldn’t keep up with demand and whilst the money was building up, when new beads, cable, fasteners, crimps etc. were needed, after having taken a small drawing per month there was not enough money to buy all she needed. The problem was that she was only looking at the GROSS PROFIT and she didn’t even consider her time, let alone any additional costs of running her business like rent, equipment etc.
Hopefully over any period, your business has a regular flow of revenue coming in from sales BUT there will also be regular outflows to cover the cost of being in business too. In order to ensure that you stay in business, you MUST ensure that your sales cover ALL of these costs – therefore you should be looking at your NET PROFIT for the period.
By definition, your Gross Profit is your Revenue less your Cost of Goods Sold (COGS) where:
Revenue: Is the total amount of sales of goods & services made by your business over a period of time (all invoices and other income amounts), representing the cost of these goods & services plus your MARKUP; and
COGS: Is the cost of all goods, materials and services (e.g. all materials, production staff salaries, labels, packaging, transport etc. – see our Blog on Costing your Goods & Services – are you getting it right). To be sure you are including all costs, look through all your accounts at what you are spending money on – if the money is being spent on your goods & services for resale, you MUST include these in your COGS, otherwise your selling price will not be accurate.
Your GROSS PROFIT should then be the money that can be used to pay the other costs of doing business as these fall due (though here too there are complexities – see our Blog on Net Profit vs Cash Flow Positive).
‘Other’ costs that cannot be tied directly to goods & services might include support staff salaries (e.g. a bookkeeper), office rent, office supplies (though for e.g. an architect, these would form part of their COGS), bank fees & charges, software licenses, bank interest etc. These costs are typically where businesses go wrong, as it is easy to lose control of the amounts spent if budgets and particularly, performance against these budgets is not monitored.
Each sale therefore makes a contribution towards paying these operating costs and if your sales are not adequate, then you will not cover these costs and you will experience a net loss. Unless you have access to financing, a business cannot make losses for long before it goes out of business.
INCREASING YOUR NET PROFIT
Based on the definition of NET PROFIT (REVENUE less COGS less OPERATING COSTS), you have a number of options:
1. Increase your Gross Profit
To increase your Gross Profit, you need to either:
- Increase your Revenue by selling more … (but if this were easy, everyone would do it)” NOTE: Beware of trying to increase sales by reducing your selling price as if you haven’t got your costings right to start with, this will make a bad situation worse;
- Increase your Markup and therefore your Selling Price (but again – you are competing with other businesses so if your pricing is too high, your sales will actually drop – reducing net profit further); or
- Reduce your COGS – you might be in a position to negotiate the cost of goods & services with your suppliers, based upon the volume of your purchases, possibly paying them early and getting discounts – BUT beware of the cash flow implications, changing the non-essential specifications to reduce costs etc.
2. Increase your Net Profit
By reducing Operating Costs – typically this is the best option (though it can be taken too far).
- If you don’t have a budget – prepare one by looking at your costs and being brutal – if the costs do not contribute towards the goals of your business (acknowledging that some of these might be non-financial), look to trim these as far as possible. The acid test is to cut out non-essential, non-contracted expenses entirely and see whether it matters.
- Look at any contracts that you might have and determine whether they add to your organization – this might include rental, equipment or even staff agreements. If you believe they are not required – try and negotiate an exit to the contract or at least better terms.
- If you have existing business loans, try to renegotiate the terms – specifically, ensure there are no early settlement penalties BUT wherever possible, push ALL available funds into the loan (assuming you can draw down these funds again at a cost that doesn’t exceed the interest saving) and pull it out again when you need it – interest is generally calculated on the daily balance and compounded (i.e. you pay interest on today’s balance PLUS interest). Note too – if you use your credit card to buy materials for your customers, bill them as soon as possible and maybe even charge them the interest cost but try not to use these funds as it is VERY expensive!
- Take control of the company’s finances – do not allow expenditure (cash OR on account) that has not been duly authorized.
- If you are making some profit and therefore subject to tax, engage a good tax accountant that might help you save on tax payable.
Your goal should be to monitor your Net Profit every month and try to increase it quarterly through a combination of the above. If you are able to make gradual improvements, this will result in a far more ‘successful’ business.
Disclaimer: The advice provided on this blog is general advice only. It has been prepared without taking into account your objectives, financial situation or needs. Before acting on this advice you should consult your accountant or professional advisor.