Author: Anna Steinfest
Profit leakage can significantly threaten your company’s financial health, hindering growth and impeding success. If you find your profits stagnating or diminishing despite increasing sales, it is likely that profit margin killers are silently eroding your business’s vitality.
Margin killers encompass various oversights and inefficiencies scattered throughout your operations, which may appear insignificant individually but collectively have a substantial impact on your company’s prosperity. The ability to identify and eliminate these margin killers is what distinguishes successful enterprises from those that struggle to survive in any industry.
To combat margin killers effectively, it is crucial to gain a comprehensive understanding of profit measurement through financial statements. Two primary measures of profit are commonly employed:
Gross profit: This measure reflects the funds remaining after accounting for direct costs associated with product manufacturing or service delivery. Direct costs typically encompass labor, materials, and other expenses directly linked to production. For instance, in the provided income statement example, gross margins, equivalent to gross profits as a percentage of sales, account for 56% of total sales.
Net income: A more comprehensive measure, net income considers not only direct costs but also various other expenses, such as overhead to sustain business operations, taxes, and interest paid on debts. After accounting for overhead costs, the net income margin amounts to a mere 12% of total sales.
As illustrated, margin killers can lurk within various expense categories. It’s crucial to identify and address these issues to prevent financial leakage and optimize both costs and revenues.
With this in mind, let’s examine five common margin killers and explore strategies to eliminate them:
1. Inaccurate Pricing that Misrepresents True Costs
Companies often overlook or underestimate expenses when setting prices. For instance, a landscaping company may charge solely for the workers’ time spent on a project without factoring in travel time. Similarly, a manufacturer may establish prices that fail to cover essential overhead expenses like office maintenance, equipment upkeep, or accounting services.
To mitigate this margin killer, it is imperative to thoroughly analyze both direct and overhead costs, ensuring that all expenses are accurately incorporated into profit margin calculations and pricing. This becomes even more critical during periods of rising inflation when suppliers increase their charges. Aligning prices with the current economic reality is necessary.
Concerned about potential customer attrition if prices are raised? Sometimes, making tough choices and having difficult conversations is an essential part of running a profitable business. Transparently communicate to your customers the necessary costs involved in providing them with a product or service. If your company is unable to remain competitive at a fair price, strategic adjustments to your business and operating model may be required.
2. Holding onto Unprofitable Products
Some products may unknowingly drain your resources and profitability. It is vital to analyze your financial data to determine the profitability of individual products and services. This analysis will likely reveal a mix of successful and underperforming offerings.
Once you identify unprofitable items, consider the following actions:
Can you increase prices for these items to improve their profitability?
Should you retain certain products due to their strategic importance in winning other sales?
Is there a more efficient way to produce or offer these products?
Or, do you need to remove them from your portfolio altogether?
3. Inadequate Management of Customer Relationships
Certain customers may demand more time and attention, resulting in increased costs for your business. For example, they might deliver necessary documents late or request changes or additions not initially covered by the contract.
Unfortunately, companies often accommodate such requests without charging appropriately. In one construction project, we discovered that the company provided free work on customer changes, amounting to 10% of its total project revenues.
To address this margin killer, proactive planning, and vigilance are essential. Establish clear guidelines in your contracts regarding how changes and add-ons will be invoiced. Ensure that your team informs you about unanticipated requests before performing the work and promptly communicates the associated costs to the customer.
4. Uncontrolled Growth of Direct and Overhead Costs
Rapid revenue growth can sometimes lead to a lack of expense control. It is crucial to closely monitor where your financial resources are allocated, as escalating costs without corresponding revenue increases can be detrimental.
Maintaining a close eye on your gross margins is essential. If you notice a decline, it may indicate a decrease in productivity, demanding immediate attention.
To effectively control overhead expenses, establish budgets for each expense category based on careful analysis rather than relying solely on the previous year’s figures. Any significant increase should be justified with a solid business case.
When it comes to expense reduction, prioritize using the 80/20 rule. Identify the expenses that constitute 80% of your total expenditure and focus on reducing them first. This approach will yield the greatest impact for your efforts.
Additionally, periodically evaluate fixed costs, such as insurance, telecommunications services, and maintenance contracts, to ensure you are obtaining the best possible deals from the market.
5. Underutilization of Technology
Technological solutions play a crucial role in identifying and eliminating profit killers. Leveraging appropriate tools can help you identify areas where profit is leaking and optimize various aspects of your operations, customer relations, and pricing strategies.
Accounting software can assist in calculating profit margins, tracking expenses, and monitoring key performance indicators like asset turnover. Manufacturers can utilize software to track downtime during factory line changeovers and equipment repairs. Similarly, timesheet tracking software can help monitor worker productivity and generate data for invoicing.
Once you identify margin killers, work towards continuous improvement by utilizing dashboards and key performance indicators (KPIs) to monitor your progress toward predefined goals.
Maintain Constant Vigilance on Margins
Safeguarding healthy profit margins is crucial to ensure your business generates the necessary funds for reinvestment, competitiveness, and sustained growth. By diligently addressing margin killers, top-performing businesses strengthen themselves year after year. Stay committed to monitoring and optimizing your margins to secure the financial health of your enterprise.
Image credits: Tima Miroshnichenko / Pexels