Why You're not as Profitable as You Want

Being profitable is not that complicated. It is also not necessarily easy but I believe most see understanding the numbers as being a complex monster so they stay away. Here it is in a nutshell:
1. Know your margins
2. Budget for profit.
3. Manage your fixed costs
 
1. Know your margins
It all starts with margins. If you don’t know how much money you make when you make a sale, it is very hard to know how to make money in your business. Where this gets complicated is when you need to factor in varying types of labour (some directly attributable, some not), costs that are shared with other income streams (e.g. depreciation of equipment). To keep it simple, I believe you should only account for costs in your margin that can be easily tracked as  direct cost to that income stream (i.e. direct labour and materials) and put all other less direct costs into your fixed costs. From here you need to understand your business model – i.e. how much sales to you need to make at what Gross Margin to make the profit you want.
Here’s an example:
A dive company needs to allow for its equipment when they quote on a job. They could try to say “we use the equipment for about 4000 hrs before it needs replacing and it costs us $8000, therefore it costs us $20/hr so we’ll charge it out at $50 to allow for 40% margin”. That formula works but can be difficult to always know how long equipment lasts and can be a lot to keep track of. The other problem is, this works well if you are running at maximum utilization but if you’re not, you may not allow enough to cover fixed costs.
It is better to look at it from a macro level. For example:
I’d rather see them say “our fixed costs (including depreciation) are around $1.2MM per year and we want to make $300,000 profit. Therefore we need to cover costs of $1.5MM. We will aim for a 40% Gross Profit Margin (based on experience and market) therefore need $3.75MM in revenue to achieve our profit goals ($1.5MM / 40%). If we are running 3 crews they each need to generate $1.25MM of revenue or assuming a utilization rate of 90% and 2000 hrs/year, they need to generate $694/hr ($1.25MM / 2000 / 90%). Now we can track utilization rate and sales per team to see if we are on track. All marketing and efficiency can be geared around those numbers.
This approach enables us to more easily track job costing (because you only need to track the direct costs that are easily accounted for) which makes margin easier to track.
The main danger with using this method is if you get big swings in fixed costs (i.e. depreciation) then you need to be aware of that and adjust accordingly. If this is the case then I’d suggest that needs to be examined more closely.
 
2. Budget for profit.
In his great (and sometimes interesting) book “Profits aren’t everything, They’re the only thing” – author George Cloutier wisely advises when setting budgets, start with a conservative sales estimate followed by allowing for your profit. Then extrapolate your Gross Profit (using your targeted Gross Margin %). Then what ever number is left when you subtract your profit from your Gross Profit, that is what is allowed for fixed costs.
This approach make you sweat. But when you do it, it forces you to take a hard look at your numbers and see what decisions your making. At the end of the day, your financial statements are just a reflection of choices that have been made within your company. This process makes give you a new perspective on how to make those choices.
3. Manage your fixed costs.
It always fascinates me how few people understand their fixed costs. I.e. how much does it cost just to open the doors everyday before you’ve even made a sale. Fixed costs can creep massively when times are good and is usually something people are on when times are bad. The trouble can be if you’re not watching them closely and the creep happens, you are leaving money on the table.
Once you’ve set your budgets in the step above, hold people accountable for maintaining them. This is an area where profit sharing and open book management can be extremely powerful (see Jack Stack book – The Great Game of Business)
 
Good luck and let the profits roll.
 

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