Flatten Costs to Fatten Profits

September 28, 2012, 9:15 am Sue Hirst Yahoo!7

One of the very best ways to achieve profit is through tight cost controls.

Flatten Costs to Fatten Profits

You work hard in your business… but is it delivering the profit you’d like?

In a competitive, price conscious market, one of the very best ways to achieve profit is through tight cost controls (especially labour).

If you’re being squeezed on price you need to be confident that you can make a profit at the price you’re charging. The place to start with pricing right is knowing the ‘true cost’ of your product or service.

This is an issue we often see in our work with business owners… they’re so busy doing everything that they don’t keep track of costs and suddenly find they’re selling at a loss!

If you can’t make a gross profit from business, it follows you’re not going to make a decent net profit, and possibly going to make a loss if overheads are out of control too.

Managing cost structure is one of the best ways to improve profit as it has the biggest impact on net profit.

''For example:

If a business turns over say $5m and the costs are 70%, you’ve got a gross profit of $1.5 to cover overheads and hopefully leave a net profit.

If you can reduce costs to say 65% - that would deliver an extra $250,000 onto gross profit, which would most likely all go straight to the bottom line.

This would be quite difficult to achieve with increased sales or reduced overheads, as extra sales carry extra costs.''

Costs are often referred to as direct costs, cost of sales or variable costs. These differ from overheads, which occur all the time whether you sell anything or not.

For a product based business costs include:
• Purchase price of product
• Currency fluctuations, if importing
• Freight to get goods into store

• Storage costs

For a service based business costs include the above, if materials are involved, plus:
• Labour
• Travel to get to jobs

• Rework

Once you know what all the costs are, you can quote with confidence that you will make a profit.

Once you’ve won the quote, it’s time to deliver, hopefully in line with your expectations. This is where things can get out of hand if not tracked carefully. It can be very difficult to achieve this without systems in place to help.

More From Sue: Why Profitable Businesses Can Go Bust

Measuring in business is vital to profit. There are lots of things you can measure, but if you just do one thing, measure costs.

The best way to measure costs is to set up your accounting and operational systems right. In your accounts system it’s vital to separate costs and overheads.

Items like purchase of products, freight in, storage costs and labour on jobs should be separated from overheads. This enables you to keep track of your gross margin percentage.

Measuring percentages makes it easier to see changes and trends more quickly. By only looking at dollars it’s too easy for things to get ‘out of whack’ and fail to see trends.

''For example:

If your sales in Year 1 are $1m and costs are $700,000 – you’ve got a gross margin of 30%. In Year 2 if sales are $2m and costs are $1,500,000 – you’ve got a gross margin of only 25%.

Your gross profit dollar figure has gone up but your gross margin percentage has gone down. Then you’ve got overheads to cover which also eat into your profit. ''

You can end up selling more… but making less money!

We see this often in growing businesses where there are suddenly more people and transactions to manage. It’s vital to have good systems in place to ensure you end up with a profit from all your hard work.

If you’re in a service based business then a job management system is vital.

In growing serviced based businesses, we often see jobs going uninvoiced, labour not being recovered, labour staff doing too much unbillable time, over invoicing from contractors, jobs where not all labour and materials are invoiced and retentions not being invoiced.

Imagine the value of these omissions!

More From Sue: How to Make ‘Incentives’ Pay in Your Business.

The cost of a good system would pale into insignificance compared to the value of avoiding these mistakes.

Another issue with costs, is not understanding the difference between margins and markups.

Costing and pricing is a key area in tenders and it must be correct and commercially attractive. A prevalent problem is getting simple mathematics wrong.

When pricing a tender, companies start with quantities and costs for materials and labour, (e.g. construction, tradespeople, software etc.)

''For example:

A mark-up is added to a cost base of $1,000. Plus 40% equals a sell price of $1,400, but the gross margin is less than 28.6%!

It all falls down in the language and assumptions. The boss says the job margin target is 15% (common in construction and related industries) so staff use this figure and slot it into the mark-up %.

The actual margin then drops to 13.1%. With actual cost blowouts in delivery, the margin often ends up less than 10% andsometimes down to low single digit percentages. ''

You then have to pay overheads and hopefully end up with a profit for shareholders.

CAD Partners CFO On-Call is a team of financial and business advisors who work with open-minded people committed to business growth and achieving success.