Introducing the profit triangle
The easiest way in which to gain an understanding of how profit is made in a business is to simplify things by examining three interrelated things: Margins, Volumes and Expenses, and to gain an understanding of how they relate to one another in causing profit.
Before proceeding with this explanation of the profit triangle let me explain what is meant by the margins, volumes, expenses and profit shown in the above diagram.
In the context that I will be discussing margins in this article, a margin is the difference between the selling price and the cost price of the units being sold.
Volumes are the quantities (in numbers of units) of the things that are sold and the units could have any number of descriptions depending on the type of business and products being sold e.g. kilograms, tons, metres, litres, hours, days and so on.
Expenses are those costs that it takes to run the business and which remain relatively unchanged in a particular financial period. Examples are rent, salaries, insurance etc.
When I facilitate sessions with groups of managers regarding what is needed to improve profits in their companies I ask them for specific ideas on how they think they can improve profits. I emphasise the need for them to come up with specific ideas. This is sometimes difficult as I often hear “Increase volumes” or “cut overheads”. These are not specific. When I ask how they will increase volumes they are often at a loss. I also ask which overheads and they also come up with non-specific ideas. To me a specific action is one that can be given as a clear instruction.
What is needed is to look at each part of the triangle and to see what can be changed to increase profits.
Let’s start with margins. There are two things that can be changed. The selling price or the inbound cost of the product. Or both.
Selling Prices. The common wisdom is that if selling prices are increased sales will decrease. This is not necessarily correct. A survey conducted (there were responses from 2,463 companies) showed that if they increased their selling prices by 1% their profits (on average) would be increased by 11.1%. This is clearly a desirable outcome. So how do we increase selling prices?
When attempting to make sales salespeople often focus on the great features their product has. People don’t buy features – they buy solutions to problems. Salespeople need to know enough about a customer’s problems to know what they cost the customer. Their explanation, of how the product or service can solve the problem at a lower cost than the cost of the problem, will make the customer less sensitive to the price. In addition, demonstrating a knowledge of the customers’ business will help establish a relationship with the customer. There are far too many canned presentations being used.
It is extremely difficult to buy from certain companies. If, for example, Telkom could reduce the psychological pain in doing business with them they would be able to charge that 1% more.
Also remember that excellent service in providing the product and ongoing support (where applicable) will also reduce a customer’s focus on price alone. There is also the factor of higher prices being an indication of quality.
Reducing the cost of inbound products. Here the usual way is to make bulk purchases. But this can be problematic. Buying more does not mean that more will be sold. The ‘hidden’ or holding costs need to be considered.
Interest. If a company that is in a borrowed situation it is, in effect, paying interest on unsold stock. If the company does not borrow money it is losing the opportunity to invest surplus funds and earn a return on them.
Obsolescence. When stock is around for longer there is the risk that the product may go out of fashion and may not be sold. There is also the risk of damage when being stored for lengthy periods. And the increased risk of theft.
An additional factor to be considered when buying in bulk is that prices for that product may go down. If bulk purchases have been made it may be that competing companies who have not bought in bulk now enjoy lower input costs putting the bulk buyer at a disadvantage.
Increasing Sales Volumes. Sales volumes don’t just increase on their own. Companies may have to spend money on additional training, additional sales incentives, additional advertising and discounts (never engage in discounting – it comes to be permanently expected by customers). All of these cost money – and unless the total of the additional margins far exceeds these costs this could end up being a waste of time. Also remember that ‘buying’ market share does not always increase profits.
Cutting Overheads. It always amazes me that this is often the first target in most companies. In the survey I referred to above the benefit of a 1% reduction for the companies surveyed gave them, on average, an increase of 2.3% in profits.
Headcount is usually the first target. In 2008 large South African commercial bank made major cuts to the number of managers it employed. Those were bad times for most businesses. Now that bank is doing very well. I wonder whether the savings made after the cutbacks will be outweighed by recruitment costs, training costs of building up their management team again.
Sometimes companies will take away small benefits their staff value. I’m not suggesting that companies should not ensure that every Rand that they spend is well spent – but if you annoy your staff they’ll get you back.
Positive ways to reduce overheads should be explored.
- While face-to-face meetings are good these can be kept to a minimum by using Skype conferencing or teleconferencing. This will produce a significant reduction in airfares and accommodation costs.
- See whether VOIP services are available that will deliver savings compared to the usual landline telephone services.
- Electricity costs can be used by installing lighting that uses less electricity. In factories that are billed for electricity on a peak demand basis ways should be sought to reduce peak demand without adversely affecting production. This has successfully been done by many companies.
- Investigate whether some of your staff can work from home. This will enable the use of less office space. You will, however, need to ensure that deliverables are clearly defined, agreed to and monitored. Excess office space can be sublet subject to lease conditions.
- Use free lancers to undertake projects rather than employing more permanent staff. If any of the free lancers stand out as stars you can make them an offer of permanent employment.
- Look around the business and if you see anything that is not used every day or has not been used in the past month sell it.
- Examine all the items that are dumped into expense accounts called ‘Miscellaneous’ or ‘General’ there is often a lot wastage there.
- Examine all activities to ensure that there is not duplication of activities in different departments. There could be a saving if the activity is centralised and carried out by fewer people.
- Company vehicles are often abused. Technology is available to monitor how vehicles are being driven and where they are. Fuel consumption should be monitored to see that fuel is not being stolen.
- Ask staff for their suggestions regarding possible savings.
All managers and staff should be equipped to understand they Profit Triangle and encouraged to constantly review operations to seek out opportunities to improve profits.