This article was written by David Lightfoot of David Lightfoot CFO, LLC.
The first step toward successfully evaluating your company’s financial health is with timely and accurate financial statements. But what if you’re getting accurate financial statements on a timely basis, but the profits aren’t up to your expectations? Where do you look next to create a plan to improve your business’s profitability?
First, Figure Out What’s Normal
Profit margins vary a lot by industry. You need to know what is normal in your industry and what is reasonable to expect. What are your competitors getting? There are publications and websites with this information. Your banker can be helpful too, as they’ve got access to Risk Management Association (RMA) industry data.
Maybe you learn what is normal and your company is below industry norms. What then? Some people will tell you to raise revenue and lower expenses! Well, duh! Or tell you that you need to “work smarter.” Double duh. Or my favorite, these companies that solicit consulting contracts by saying something like, “If you just raise sales prices by 4% and lower costs by 4% and grow 4% per year compounded, you’ll make lots of money.” Triple duh!
What we really need here is objective information that is actionable. What do I mean by actionable? I mean, information at a level that is granular enough for the business owner and their advisors to make decisions that they are confident will aid in improving profits. Let’s discuss some examples.
How Pricing Affects Profit
Let’s start with the top-line — revenue. Without even doing any margin analysis, are you charging enough? If you’re in a professional service, typically you want to charge-out your billable people at 3X their gross, unburdened pay. How about labor efficiency? Again, for professional services, your producers should be 75 to 85 percent billable to clients.
Here’s another example. If you’re a construction contractor that bids work in a competitive environment, what is your success rate? If you’re getting awarded over 50% of the jobs you bid, you’re probably bidding too low.
How Gross Margin Affects Profit
With gross margin, the first challenge is calculating the margin correctly. The topic is too much for the space I’ve got here, but you need someone who knows how to calculate gross margin correctly. Once you’ve got a proper gross margin calculated, what is normal? It depends on your industry. Staffing companies may do well to get 15%. Construction contractors expect 20 to 30 percent. Professional services should be 50 percent or better. Software companies sometimes can achieve 95 percent.
Gross margin is the quantification of your value proposition. It is also the aggregation of all your transactions for the period. If you’re in a Job environment, you need to do Job Costing. This will reveal that some Jobs make more money than others. Are there patterns? Usually, there are Job types, certain customers, certain geographies, certain foremen or some other variable, that does better than others. Now you’ve got something that is actionable. Do more of what makes you money and less of what doesn’t. This may mean raising prices, lowering prices, firing customers, getting out of certain lines of work, making personnel changes or a number of other paths. The point is, you’ve got objective data to base decisions on.
If you’re not in a Job environment, often similar analysis can be done by product line, service line, location, salesperson or any other variable. The goal is to find what variables drive profit. And then base decisions on those drivers.
How Overhead Affects Profit
What if your pricing is where it should be and your gross margins are solid? What’s left? Overhead. Attacking overhead costs requires a different approach. First of all, while human nature seems to be to go after cell phone and office supply costs, the big money in overhead is typically people. Yeah, it is awful to do, but sometimes you’re just overstaffed.
Technology also provides opportunities to automate processes that were previously done by people. I also find clients are allowing more virtual work (reducing facilities costs) and off-shoring of certain tasks. In my experience, I’ve seen workers in India, China and Latin America used. In every case, it has been to facilitate growth rather than cut local employees.
And then there are Sales and Marketing costs. This is another topic too big for the space I’ve got here. But measuring the effectiveness of your Sales and Marketing functions is critical.
Planning For a Profitable Future
The type of analysis I’m describing here can sometimes be done by accounting or operating staff. But often, this is beyond the skill levels of normal staff, even Controllers with CPA licenses. Often, this is the sort of thing a CFO can tackle by looking not only in the rearview mirror but also planning so the owners and managers know where they need invest in the business for its success.
Ready to learn more about becoming a profit-focused business? Join us at Equinox for a discussion with David Lightfoot May 22nd at 7:30 am. Full details and registration here.