Many businesses start their new financial year in April, so it is
a good time to sit back and review where you are heading over the
next twelve months. It may just help you get a little richer next
year. We are not proffering a magical, get-rich-quick formula - but you will find some commonsense suggestions to help you better plan your year.
This article examines some ways of increasing the available PROFITS you have at the end of the year, to either take as drawings, salary or dividends.
The approach can apply to any size of business, but today we are going to take a look at the profitability of an established, successful fast-food shop owned in partnership by Mr and Mrs Smith.
| Results for the year ending 5 Apr 2005 £ |
|
| Sales |
150,000
|
| Cost of sales |
(60,000) |
| Gross profit |
90,000 |
| Gross margin |
60%
|
| Indirect costs |
(42,000) |
| Net profit |
48,000 |
| Net margin |
32%
|
As we go, we could discuss the revenue-creation and cost-saving measures the Smiths may consider taking to improve their profitability. Valid as this approach may be, we shall ignore it for the moment. There is a more important first step that many people forget to take altogether.
We are going to turn the matter on its head. We will ask Mr and Mrs Smith to identify what level of profits they would like their business to generate, so that they can meet whatever personal commitments they may have over the next twelve months.
Having arrived at a realistic personal take-home requirement, we can work back up through the profit and loss account to calculate the necessary revenue they need to achieve this worthy goal.
This approach is the exact opposite of the way most of us traditionally think about managing our business. When you mention increasing profitability, most people will instantly jump in with ways of increasing sales revenue, and devising new cost-cutting measures.
Leaping in feet first is the quickest way of falling into the trap of becoming very busy people that end up making no extra money. We see it time and time again as accountants.
Faced with working out what they want out of life in 2006, the Smiths recognise there are two contingencies over and above their normal cost of living expenditure they wish to plan for. They have been advised that the family home needs a new roof, and a new car would be nice.
They determine that they can comfortably afford both, provided the business generates an extra £12,000 profit over last year's results.
Now that we have established a target net profit of £60,000 (£48K + £12K) to aim for in 2006, it is a fairly straightforward mathematical exercise to work back up the profit and loss account to calculate the increase in sales revenue the Smiths will need.
You may be tempted to just apply the Net Margin of 32% achieved in 2005, and multiply the required £60,000 net profits by 100/32 to arrive at a target sales figure of £187,500 for the forthcoming year.
If you were to do it this way, you will end up wildly overstating the level of sales actually required to achieve the target £60,000 profit. As you will see in the next section, the Smiths in fact only need to increase their sales to £175,000 - not £187,500.
The reason for the significant difference is the one-stop, 'net margin' calculation overlooks the fact that many of the types of expenditure listed within Indirect Costs are likely to be 'fixed' in nature.
The type of expenditure we are discussing here, may well rise in line with inflation or other external market factors, but they do not vary with the volume of sales. To apply the net margin calculation to these 'fixed' costs distorts the final target sales figure.
Items such as rent, rates, electric, and gas are typical examples of annual expenditure commitments that tend to remain fairly constant year on year.
Before we can accurately forecast the level of sales required - the Smiths need to quantify the level of fixed expenditure they expect to incur during the forthcoming year. This is best achieved by reviewing the actual 2005 expenditure. Then adjusting for inflation to arrive at a figure for the next twelve months.
Only then can you safely apply margin percentages to calculate the required level of sales, which we now go on to demonstrate.
| Actual
Results for the year ending 5 Apr 2005 £ |
Forecast
Results for the year ending 5 Apr 2006 £ |
|
|
| Sales |
150,000
|
175,000
|
|
| Cost of sales |
(60,000) |
(70,000) |
|
| Gross profit |
90,000 |
105,000 |
|
| Gross margin |
60%
|
60%
|
|
| Indirect costs |
(42,000) |
(45,000) |
|
| Net profit |
48,000 |
60,000 |
|
| Net margin |
32%
|
34%
|
|
The first step is to increase all the fixed costs by at least the rate of inflation. It may also be possible to identify certain types of expenditure that may suffer greater increases over the next twelve months. You may agree that insurance premiums, rates, and travel (petrol) are the most likely candidates to see steep rises in costs over the next twelve months.
These are the kind of factors that the Smiths have allowed for in their workings. They feel that the costs of rent, light and heat are likely to remain fairly much as they were last year.
Salary costs do not necessarily have to rise to support the increase in sales revenue but the extra work may result in overtime if not the need to take on new staff. For this reason the Smiths are being prudent in providing for increased staff costs. If the additional sales revenue required can be achieved by improved staff productivity, rather than increased wage bills, then so much the better for the Smiths.
On the good news front, interest rates look as though they are going to continue to remain stable. The Smiths may even be able to lower their annual finance costs by refinancing their debt to take advantage of the many low-rate loans that seem to be on offer at the moment.
After reviewing the 2005 expenditure, the Smiths conclude that the year 2006 Indirect Costs figure is likely to rise to only £45,000 (2005 - £42,0000). And that's after taking into account the cost they predict will be needed in carrying out some essential repairs to their cooking equipment.
The Cost of Sales is simply the balancing figure, and is calculated by taking £105,000 from £175,000 to arrive at £70,000.
Remembering that the Smith's business is an established one, if they were asked how much they felt they could raise their prices by before carrying out the exercise above, we bet they would have suggested nothing higher that than the just above inflation. Say 5-8%.
We are talking here about increasing sales revenue (or cutting costs) by at least 17%, in order to achieve their goal. Is this being unrealistic?
Who knows? The point we are making is that Mr and Mrs Smith would never have attempted to increase their productivity by 17%, without first looking at their own desired income requirements. If this isn't enough of a reason to motivate them to try for gold, then nothing else will either.
But just for the record - here are a few ideas for achieving that 17% increase!
To put the importance of order up-selling into perspective - consider this. If the Smith's average order value is £4.00 then they would only need to encourage customers to increase their order by 67p to be well on their way to achieving the new sales target. In real terms this is only a portion of coleslaw, or perhaps a drink. No matter how small your operation may be - train your staff to treat every order as an opportunity to increase revenue.
Provided realistic targets are set that can be achieved, and pay packets do reflect success or failure to meet those targets, then this kind of approach can be very effective.
Formalised loyalty reward schemes are one option - and no one is too small to make this work for you.
Simply making an effort to get to know your customers, using their names, and spending the time of day with them, can all produce dramatic uplifts in the amount of business they pass your way - even if it just by recommendations alone.
You can count on it!
Each client is unique, and we will always be pleased to work through the same exercise with you on your own business.
We can work with you to demonstrate that by identifying where you want to be in twelve months time - really can ensure you get there.