Editor’s note: This article was first published in July 2011, during Spain’s recession. The references to “the crisis”, “the coming months” and customers focused more than ever on saving reflect that context.
Hundreds of business owners will have to sit down and go through their accounts carefully, especially at small and medium-sized businesses, since small business owners tend to neglect basic finances. Over the coming months, some of them will discover that their company is in one of these two situations:
The one who sells more at a lower profit margin. This owner will find that the business isn’t profitable, because this approach is losing money. We’ll explain why shortly.
The one who sells less but at a higher margin. In the middle of a recession, when regular customers are more focused than ever on saving, this owner may notice customers drifting away, which in the long run leads to the same place: more profit per sale, but few sales, so the business isn’t profitable either. Crazy, right?
A few years ago, my job was advising companies both on their customer-facing marketing strategy and on how to position their product or service in the market. Luckily I no longer do that, because I have to admit the crisis has made things hard for small and medium-sized entrepreneurs, at least when it comes to deciding which strategy to follow. Even so, it’s a matter of putting our brains to work and adapting our product to what the market needs. Some will be forced (by the numbers) to choose one of these two paths.
Work out the net profit of your product or service
There’s little we can do if we don’t know how much we earn when we sell a product or provide a service to a customer. I’m convinced that if many companies ran the numbers, they’d find that, while they think they’re making money because they see cash in the bank, they are actually digging a huge hole in their finances.
If our business is a factory, working out the cost of a product is harder because, as we’ve said on several occasions, manufacturing is where losses tend to hide, since costs can’t be 100% controlled.
Still, a simple, effective, homemade way to work out the profitability of a product or service is a “cost and profit per product” analysis, together with a calculation of the fixed and variable costs of making or distributing a given product.
- Write down the gross income from your customers over the last 12 months.
Then start subtracting:
- Fixed costs: rent on the premises, instalments on machinery, workers’ wages and insurance, and so on.
- Variable costs: extra labour hired, electricity, delivery company charges and any other expense arising from making or selling the product.
- Payments to suppliers over the last 12 months.
If you’re not sure how to tell fixed costs from variable ones, we explained it in a previous article: Analysing fixed and variable costs.
Once you’ve done these homemade accounts, you’ll probably find that the result is negative, so it’s time to look at which expenses you can do without, or how to approach things to increase profitability, ideally without increasing spending.
With this we’ve analysed the profitability of our business, but now comes the hardest part: to increase the profitability of the business as a whole, you have to increase the profit on a particular product or service, so now we need to work out the real price of our product. Business owners with a factory will find it harder to know the real cost of a product.
Going back to homemade accounting, and assuming you run only one production shift (if your company has two shifts, the operation is the same, but split by shift, loading the corresponding costs onto the shift that generates more of them; this way you can also find out which shift is more profitable or productive), let’s start with some basic maths.
Here we’ll calculate the cost of a product based on a single normal production day. First, divide the costs above by 12 (since we calculated them for the whole year) and then by 30 days. Now you know what your business costs every day just to stay open. Scary, isn’t it? Important note: take out only the invoices from suppliers of the materials used in production, because we’ll add that cost directly.
- Count how many units were made by the end of the shift.
- Work out the final price you sell the product to the customer for, everything included (final price).
- This goes without saying: multiply the final selling price of the product by the number of units made by the end of the shift.
Now subtract:
- The cost of the materials needed for production. Include every screw, every piece of metal or plastic used (EVERYTHING).
- The amount we calculated earlier (the daily cost of running the business), which covers wages, electricity, water, rent, deliveries and so on.
Divide the result by the number of units made, and that will be your gross profit per product made and sold.
Once you know how much you earn on each product, you know whether you’re making a profit or a loss, or simply whether the profit is enough for your business to survive and last over time. By now the strategy you need to follow should be clearer: either you sell more, because you have no choice, or you raise the profit on the product by increasing its price.
After doing this simple calculation, many companies discover they would earn much more by giving up manufacturing and buying the finished product from a distributor, which, as a large factory, follows a strategy that works for it: sell more for less.
For small and medium-sized businesses, I always advise selling more for more: in other words, finding a way to keep an attractive profit margin while winning new customers. If at some point we find ourselves in front of a big potential customer, we can always cut our margin to win them over (more for less).
This profit-per-product calculation is used even in restaurants, where they work out the final cost of a steak or an egg, including gas, electricity, the cook’s labour and the wages of the waiter who carries it to the table, and even the cost of the cleaner and the dishwasher. Some restaurants have done such meticulous accounting that they know a single French fry costs them €0.09. That’s why many restaurants, after running the numbers, turn to catering companies to become more profitable.
Finally, if your business doesn’t involve manufacturing and you’re simply a distributor who buys at 5 and sells at 8, calculating profit per product is much simpler: you just do the same calculation as above, without having to work out the costs associated with production.
It’s also worth stressing that business success isn’t all about price. The quality of the product or service and customer care count too, and in many cases customers don’t mind paying more if they get added value. So also look at what your customers need and how they think about it.
Sorry this article is so long, but the situation called for it.
Further reading
- Make or outsource manufacturing: which is more profitable?
- 5 ways to grow your business
- How to boost sales in a business hit by the crisis
- How to be a successful businessperson
Featured image: jakeandlindsay, CC BY 2.0, via Wikimedia Commons.
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