Often, when we look at a business, it seems that big changes are needed if the business is to achieve decent levels of profitability. However, the reality is that small changes to the critical levers in a business can lead to huge increases overall, due to the multiplying effect.
First, let’s define the main levers of the business, and then the areas that can provide meaningful impact on these.
- Revenue – obviously, sales are the core of a business; without income from sales the business ceases to exist.
- COGS (Cost of Goods Sold) – this is the purchase cost of the items you’re selling, or the cost of raw materials and direct labour if you’re manufacturing.
- Operating Costs – also referred to as SG&A (Sales, General & Admin expenses), these are the costs of running the business.
Gross Profit is, of course, the difference between Revenue and COGS, while Net Profit takes the Operating Costs out, too. Ideally, therefore, you want to increase Revenue more quickly than the COGS and Operating Costs, and this is where the magic can happen.
Let’s look now at some of the sub-levers of Revenue.
- Average Transaction (Invoice) value – considerations here would include:
- a small increase in prices – there is a ‘elasticity,’ depending on your business and the competition, where a small increase in prices might not affect the number of sales and so this would directly flow through to the bottom line as there would not be a similar increase in costs. What would the impact of, say, a 3% price increase be?
- more items per invoice – McDonalds famously increased its profitability dramatically by simply having every server asking, “Do you want fries with that” when a customer placed an order. What complementary items can be added to your invoices easily?
- Number of Customers per month – how can you increase the number of customers buying from you each month? Again, a small increase here can have a noticeable impact to your revenue and bottom line.
When it comes to the COGS levers, the main ones are about materials and direct labour. Can you decrease materials cost in some way? Perhaps consider the time value of money for your supplier – a business I ran took a 2.5% discount offered for 14-day payment terms as against the normal 45 days, using a 1% bridging loan to cover this, so banked 1.5% extra. Can you adjust your sales mix to focus more on higher-margin items? If you’re in manufacturing, can you redesign a process to reduce labour costs?
Lastly, we turn to the Operating Costs – look through these, starting with your biggest cost items to see where you can improve things.
Payroll is often the biggest cost here – do you need to immediately replace everyone that leaves, can you outsource non-core functions, for example? Look, too, at working capital use and costs – reducing your debtors’ days (DSO / Accounts Receivable) and improving inventory turns can have a dramatic effect on your business – not just in terms of direct interest costs (often significant for a business), but in terms of things like warehouse space/costs, and staff, too. Look, too, at your rental contracts – now is probably a good time to renegotiate these, with more staff working remotely and office space decreasing in price due to over-supply.
The cumulative effects of making small improvements in all these areas rapidly become significant for your bottom line. To illustrate this, let’s take a small fictional example of a business that has 100 customers each purchasing an average value of R1000 per month, making a Gross Profit of 10%, and with operating costs of 7.5% meaning a 2.5% net profit.
The monthly numbers would look like this:
100 x R1000 = R100 000.
GP @ 10% = R10 000
Operating Costs @ 7.5% = R7 500
Net Profit = R2 500
Now, imagine we can increase the average transaction value by 5%, the average number of customers by 5%, reducing the COGS and improving the GP by 5% per transaction and also reducing the operating costs by 5%. None of these are outrageous changes, but the effect on the business would look like this:
105 x R1050 = R110 250
GP @ 10.5% = R11 576
Operating Costs @ 7.125% = R7 855
Net Profit = R3 721 (almost a 50% increase!)
Understanding the major and minor levers in your business and finding ways to tweak these to even a small degree can have a dramatic effect on the bottom line and so your growth prospects and the value of the business.
If you’d like a free introductory discussion on your business, reach out to me here – I’d be happy to help.
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