Do you sometimes wonder why you’re working hard but with no or little profit at the end of the year? Could it be that you’re making the following classic profit mistakes in your business?
If so, this could be costing your business a fortune. Let’s review some profit mistakes that many businesses make and how to approach the issues differently.
1. Not knowing your gross profit margin
Gross profit is an important indicator of profitability, but it’s vastly ignored or misunderstood among most entrepreneurs. The next time you get your accounts, take the direct costs of sales or direct expenses out from the revenue. Then divide that number by the revenue. That is your gross profit margin. Let’s say your revenue is £95000 and your materials or direct labour or direct expenses cost you £60000. The difference of £35000 divided by £95000 revenue gives you a margin of 36%. This means that for every £1 of sale, you are making 36p in gross profit. How does this compare with what you had in mind? What is the industry average margin? Unless you’re making a decent gross profit margin, your whole business model needs reviewing as you’re unlikely to remain in business for long.
2. Mark up pricing
How do you currently set your prices? Do you look at your competitors and gauge your price without any regard to your costs? Or do you take your costs and add a mark-up percentage to it? Most business owners do the latter which we call mark-up pricing. This is a big mistake. Using the above numbers, let’s say you’re tendering for a significant project. You apply the 36% margin to the costs of £60,000. And you quote £81,600 for the job. Sounds familiar? And it makes sense right? Well not quite. If you take your £60,000 costs from the £81,600 revenue (price) you get £21,600. Now divide that by £81,600. You now get 26%. You’ve just lost a whopping 10% profit margin without even blinking, costing the business £8,160 (10% of £81,600)
3. Overlooked break even number
How much income do you need to make to reach zero profits? If your business is making very low profits or losses, then you cannot ignore your break even number. The reason you need to know this number is so that you know how much income to make to cover all your costs.
How do you get this number? You first need to know your total fixed costs. These are the costs that do not change regardless of the amount of sales you make. So, things like rent, admin team costs, rates and fixed line contracts.
You then need to know the gross profit margin. You divide the total fixed costs by the gross profit margin and this tells you the amount of sales you need to make at any given period to cover all your costs.
Because you’ve avoided the first profit mistake above on margins, it should now be easier to avoid this third mistake because you only need to find your fixed costs. Let’s take the 36% margin above and assume your fixed costs as £35,000.
So £35,000 divided by 36% gives you a figure of £97,222. And if your revenue is currently £95,000, this tells you that your business needs to grow its income or reduce its costs if you’re to stay in business for long.
Not applying the 80/20 principle
This principle says that 80% of your results come from 20% of your activities. Do you know the 20% of your customers who generate 80% of your profits? How about the 20% of your service or product lines that generate 80% of your profits? By not serving these vital few of customers really well, how much is this mistake costing your business? Why not spend a few hours, perhaps with the help of your accountant, and carry out the following Excel exercise?
In column A, list your 5 best customers
In column B, enter the total income you get from each customer annually and keep a total
In column C, enter the total income you could generate if you served these few customers well with your complete range of products or services. Keep another total
Now compare Columns B and C. This is the potential cost to your business of not applying the 80/20 principle.
Ignoring these profit potentials
Have you considered the profit potential in your business if you apply 4% increase or decrease in 4 areas of your business?
So consider this. 4% increase in price, 4% increase in sales, 4% decrease in variable costs and 4% decrease in fixed costs.
Most entrepreneurs are keen to bring in more sales and ignore the power of this profit potential.
Next time you sit down with your accountant, ask him or her to run these numbers and show you the impact it will have on your profits. You will be surprised how much this profit mistake has been costing your business.
Disregarding these profit warnings
There are always profit warning signs in business that often get overlooked. Some of these signs are:
- Scraps and mistakes
- Customer complaints
- Higher staff turnover
- Operational inefficiencies
- Poor stack management
- Overdue debt of more than 90 days
Leaving profits on the table
It’s always tempting to see cash in your bank and want to spend it, right? In his book Profit First, Mike Michalowicz makes a compelling case for opening another bank account and transferring your profits before you make payments to anyone. So, if you’ve worked out that your net profit on every sale is 15%, then a safe way to see and secure these profits is to transfer it straight away to your “profit bank account”. That way you are forced to make do with the remaining 85%.
If any of the profit mistakes described here are sounding uncomfortably familiar, now is the time to take action. Make some changes and the rest of the year can be much more profitable.
Further Information about the author
Jonathan Amponsah CTA FCCA is an award winning chartered accountant and tax adviser who advises entrepreneurs on business and profit improvement. Jonathan is the founder and CEO of The Tax Guys.