In my last post I wrote about having Accurate and Timely Financial Information. Let’s say you’ve got your accounting straightened out so that you have good financial information on a timely basis. Now you’ve got something to base decisions on.
Let’s assume neither your gross profit margin nor your net income is as high as you would like. How do we improve our margins? There are a number of ways to attack this.
First, let’s remind ourselves that gross profit margin (as a percentage) is the quantification of our value proposition. It is what our customers pay us compared to what it costs us to provide that good or service, without consideration of overhead. Gross Margins will vary greatly between industries. Second, remember that Net Income (as a percentage) is the most comprehensive measure of performance for most companies.
Third, remember that revenues and costs above the Gross Profit line almost all vary with sales volume. Almost all costs below the Gross Profit line are fixed monthly and do not vary with volume. Those different cost behaviors are important when trying to improve margins.
Let’s tackle Gross Profit margin first. Knowing your Gross Profit margin isn’t high enough is a good first step, but it isn’t really actionable. You can say, “I’m going to raise prices and lower costs,” but it is rarely so simple. To get to something actionable, we’re going to need more information. Such as, what is our Gross Margin by product/service line? By job? By customer? By salesperson? Typically, a company will find that they make money on some product/service lines, jobs, customers, or salespeople but not others. With that insight, it is an easy decision to do more of the most profitable lines/jobs/customers/salespeople and less of the others. Often it is helpful to rank your customers by profitability. It is common to find that 80 percent of your profit comes from 20 percent of your customers. Then you look for more customers like those 20 percenters and start getting rid of the worst of the 80 percenters.
Calculating Gross Margin by product/service line, by job, by customer or by salesperson (or any number of other ways) is a task that is not to be underestimated. Usually it requires tracking of labor costs to the cost center you want information for. That means time tracking and the allocation of fully-burdened labor costs. It is a lot more work for the accountants but much can be automated if it is set up correctly.
What it usually comes down to is Job Costing, if the company is in a Job Cost environment. A “Job” can be a contract, a Statement of Work, a Work Order or any number of things. But a Job has a definite beginning and ending. Besides tracking burdened Labor, if goods are also part of each Job, inventory tracking is the other complication.
Often the temptation is to allocate Overhead costs to each product/service line, job, customer or salesperson. Don’t. Remember, Overhead is incurred on a monthly basis and allocation to Cost of Goods/Services is always arbitrary and usually misleading. The result will be poor decision making.
I’ve had clients who, based on this type of analysis, have closed whole departments of their company. The result was lower sales with higher profits. More common is to find customers or customer types who should be “fired.” Those are the most demanding customers who nickel-and-dime you while always needing attention. You’re better off without them.
If you want to lower your Overhead costs, it may be helpful to get industry benchmarks. Also look at history within the company. With scale and automation, overhead should go down as a percentage of sales as the company grows. Another thing to note is that when Overhead is too high, human nature seems to be to attack cell phones and office supplies. I don’t know why but it could be that those costs always seem to be too much. Or maybe because the biggest overhead cost is people and it is always hard to get rid of people.
The conclusion is that with good information, at the appropriate level of granularity, management can make the decisions that improve their margins, increase profitability and contribute to cash flow. What you do with all that money is your choice, but having choices is always good.
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