How profitable is your business? How do your profits compare to other companies in your industry? These are two questions that small business owners need to consider very carefully before jumping into 2015.
Profitability can be measured in different ways but the basic measure is “net profit” which is calculated by subtracting all of your expenses including interest, taxes, depreciation and amortization from your revenues.
Sageworks, a leading provider of risk management solutions to financial services and privately held companies, recently published an analysis of net profit margins among privately-held businesses. The company analyzes over 1,000 financial statements daily from its clients and uses this information to calculate some interesting statistics on small business profitability. According to the latest data the following industries have the highest net profit margins for the twelve-month period ending in August:
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If your business generates between 10 and 20 percent net profit margin annually then you are in good company as that puts you among the most profitably privately-held businesses in the country. But what if you aren’t in that range? Or what if you have the potential to make even higher margins? Either way now is the time to start a “margin makeover” for 2015.
First: Understand where you make your profits
Before we arrive at net profit margin, we have to look further up the income statement. Gross profit is the difference between your revenues (from product or services sales) and your cost of goods sold (COGS). COGS consist of the direct expenses associated with the actual good or service you are selling. Gross profit is the money you have available to pay for all of your other expenses like salaries, benefits, office space, insurance and more. It’s nearly impossible to have a high net profit margin unless you also have a healthy gross profit margin.
Second: Prune the laggards
(If you only sell one product or service you can skip to step three)
Once you have an understanding of your overall gross profit, you have to break down it down for each good or service you sell. It’s unlikely that all of your products have the same gross profit margin. It’s important to understand how much each item you sell contributes to your overall gross margin. It’s likely that some at least some of them don’t offer much gross profit and requires a great deal of time and effort to manage. These are the profit laggards and you should seriously consider eliminating them for your offering. That effort would be better spent developing new products which we’ll discuss in step five.
Third: Rank your costs
Once you have worked on your gross profit margin, it’s time to move to the next section of your income statement – operating expenses. You should rank these costs by dollar amount and try to understand how each cost contributes to your overall business. If you can’t articulate in a clear and simple manner what a particular expenditure does for your business then you should question whether its money well spent. For most small businesses the largest expense by far will be labor. That takes us to step four.
Fourth: Optimize your R/E for your main cost
The most profitable companies in the U.S. tend to have one particular trait in common: Sales per employee are high. The revenue generated for each dollar spent on labor or (R/E) is an excellent indicator of future profitability. Netflix generates over $2.5 million in revenue per employee. This means that the company is able to leverage a relatively small base of expensive employees to generate impressive revenue numbers. They have optimized the return on their labor costs. If your business could squeeze out an additional ten percent in sales from your existing employees, much of that additional revenue would go straight to profits.
Fifth: Add new high-margin services
The most profitable sales are those that are made to existing customers. Reach out to them and find out what additional services they may be interested in purchasing from you. If it’s possible to develop an on-line, self-service version of what they want then would be almost pure profit. Facebook’s gross profit margin is currently 82% while LinkedIn stands at 87% and Yelp at a mind boggling 94%. You don’t need to transform your business into a social media website but adding a purely online, self-service component to your product mix can boost your gross margin and improve your net margin significantly.
