Effective Profit Improvement

Do you pursue effective profit-improvement programmes?
A. What is a profit-improvement programme?
B. We simply try to sell more and cut costs.
C. We have a profit-improvement programme … mainly in ‘our head’.
D. We examine and implement profit-improvement programs which combine cost reduction, price and volume changes.
E. We systematically examine and implement profit-improvement programs which combine cost reduction, productivity improvement, price, mix and volume changes.
[Score:  A=0, B=1, C=2, D=3 and E=4]
Why is this question important?

In examining opportunities for profit improvement in your business you should remember:

  • the best profit improvement opportunities in your business often arise from situations where you make simultaneous changes in costs, prices and sales
  • you should concentrate on the business activities where 80% of the results are obtained from 20% of the activity
  • you can achieve short-term improvements in profit from cost-cutting or price increases, but you need to be careful to avoid long-term damage
  • large profit improvement opportunities will require a great deal of time, planning, effort on your part and almost certainly some additional resources

3 Ways to Increase Profits

Fortunately as you are probably aware there are only 3 ways to increase profits:

  • increase the sales volume or turnover (including changing the sales mix)
  • reduce costs – both fixed and variable
  • increase the selling price (sometimes reducing prices works)

Increasing Profits

Choosing the appropriate and best method for your business is not easy – there are times when some of these methods may not work.  Obviously if you can’t sell the extra output, it is a waste of time trying to produce more.  What happens is that stocks build up, overheads rise, and your profits fail to rise and may even fall.  There is also the danger of over-extending your business and running short of working capital especially through expanding too quickly – many profitable small firms go to the wall as a result of this.  Another factor to consider is which area or part of your business to expand – obviously it is much better if you increase sales of products and services with higher margins.  Very few businesses have a single product or service; yet many cannot pinpoint their most profitable products or services accurately.  Can you?

Raising prices can be a quick and easy way to increase profits, provided there is no great loss of sales volume.  You will of course have to consider other factors including competitor response, and your cost structure.  The usefulness of these methods for increasing profits will vary from business to business and from time to time within any one business.  Reliable information is a must before you decide what course of action to take.

Take a closer look

Increasing sales volume is without doubt one of the most effective methods of increasing your profits.  It does not involve rising prices, so there is little risk you will lose customers.  You need to sell the extra output and this needs better marketing.  And the extra output must be on profitable products and services – thus you need reliable and accurate figures on costs and profit margins.

Your management accounts and information system should enable you to reasonably estimate what would happen if you increased turnover by e.g., 5%, 10%, etc.  The effectiveness of this method is dependent on many factors, among them:

  • your ability to sell the increase in output
  • your ability to identify your most profitable products/services
  • your cost structure – the mix between your fixed costs and your variable costs

Of all the methods for increasing profits, increasing sales is generally very effective – and yes, you guessed correctly, generally the most difficult.  Trying to increase sales or selling more is what everybody in business spends almost their entire business life trying to do!

Raising prices can be a quick and easy way to increase profits – but only if customers continue to buy the same quantities as before.  Remember what your customers will pay sometimes has little enough to do with cost.  You must know and understand the buyer’s motive.  An antique clock priced at € 500 is not likely to be affected by a price rise of 5%, 10% or even 15%.  Try increasing the price of some essential item by 15% – standby for the reaction!

In seeking to increase your profits you may have cut every cost in sight, have productivity on a vertical climb, sold to every living potential customer, and still not be making an adequate profit return.   What then? – really you have no option but to increase prices, selectively or across the board.   In implementing price increases there are two hurdles to overcome:

  • informing your customers in a manner which they will readily accept
  • overcoming ‘price increase paralysis’ in yourself and in your sales people

Very few customers buy on the basis of price alone.  Quality, reliability, performance, backup service, reputation, etc. are all factors which can be as important as or more important than price.   You are probably familiar with the following quote.

Remember also there are ‘other’ indirect ways you can increase prices – change the discount terms, decrease fulfilment costs, increase minimum order sizes, charge for delivery, etc.

If the increase in prices results in the loss of some turnover, it is essential that the overall effect is positive for your business.  Remember also that if there are volume effects, your underlying cost structure will impact on the effectiveness of increasing prices.

If you find it difficult to increase prices because of competition or customer resistance – this effectively eliminates one of your methods for increasing profits.  You may have little opportunity and considerable difficulty and expense in introducing a new product or service. Therefore cost reduction may remain as your only real effective method of increasing profitability.

Combining Methods

Never underestimate the effectiveness of small changes in combination – any combination of two methods you employ is generally better than a single method.

See below –  here a 1% increase in sales volume, combined with a 1% increase in selling prices and a reduction of 1% in the cost base will dramatically change the bottom line …  These are the type of changes most people would not consider worth bothering with.

From StrategyPal’s Profit Indicator.