The holiday season is upon us again, and in between family visits and turkey dinners, we may be reflecting on this year’s performance, how to improve profits and thinking what 2019 may look like. Most large corporations have been engaged in year-end planning and review activities, so why not you?
It’s a good time to ask yourself, how is this year’s performance against your budget for the year. If you didn’t build a budget for 2018, then how do you measure up against 2017? Are things better or worse? And what exactly is better and worse:
- Sales were higher, but profits lower
- Sales were the same, but profits lower
- Lower sales, but better profits
If you’re looking to improve the profitability and value of your business, there are a few things you should consider:
If your business primarily sells products then we use this formula:
Gross Margin: Revenue – Cost of Goods Sold divided by Revenue
If your business is primarily a service business then we use this formula:
Operating Profit Margin: Revenue – Expenses divided by Revenue
The higher the percentage, the better the result. This is a key ratio used to measure business performance, and ultimately this will impact the value of your business too. More importantly, by comparing margins over several years you can evaluate the fluctuations and trends in profitability.
Improve Gross Margin
There are a number of ways to improve gross margin:
- Raise prices, if appropriate and it won’t negatively impact your overall sales. Inflation-adjusted increases are generally accepted without too much challenge and this could add 2-3% to your top line.
- Evaluate your business lines by profitability. If you have multiple product/service offerings evaluate each by gross margin, and if possible by historical gross margin trends. If a product line is performing poorly or declining, does it make sense to eliminate it from your business?
- Renegotiate with your vendors: do this when you understand the value of the vendor contract. Are you using more or less from your vendors? Are they living up to their support commitments? Are there other vendors who you could do business with that would lower your costs and maintain or improve your services?
Manage Operating Expenses
Operating expenses are associated with the general running of your business. Many times, these are forgotten costs that live on year after year without a thorough review. Here are some areas to evaluate:
- Staffing: are your staffing levels and staff skill sets appropriate for your business? Unfortunately, we all know that the cost of doing business in California is expensive: minimum hourly wages are among the highest in the nation; employment laws are very favorable to employees; and health insurance costs continue to skyrocket.
- Outsource functions: Can you outsource high cost non-core functions such as human resources, technology and finance? Could you use a lower cost state to remotely support your business?
- Automation: Are there areas of your business you could automate to improve efficiencies? An example is a medical practice still using paper-based forms for patient onboarding. Consider using a combination of tablets and online forms.
- Risk Management: Risk management costs are an increasingly significant cost for California businesses. There are a number of different options worth considering to reduce your insurance costs including group collective and self-insurance.
While this might be the last and to some, the most obvious point, growing sales doesn’t make sense if your return on investment doesn’t stack up. The only way to know if growing sales is going to improve your profitability is to understand your profit margins.
Bringing it All Together
You can improve your profitability by analyzing the quality of your profits and margins. Can you identify the areas of your business that are doing well and those that are not? Where do you need to put your efforts into reducing costs, improving productivity and maximizing profitability? The better your understanding of the profit drivers, the better you’ll be able to maximize the value of your most valuable investment: your business.
Shannon Lowther, CFA, ASA, ABV, is managing partner with Bakersfield-based Central Pacific Valuation. She specializes in the valuation of businesses, business interests and intangible assets. Shannon can be reached at email@example.com