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You need to work on profitability as much as you do on sales
When they start out, entrepreneurs often put most of their effort into finding customers and generating sales. That’s understandable — without customers and sales, you don’t have a business at all.
But in the longer term, the whole point of launching and running a business is to make a profit. If you plan to live off the income the business generates, its level of profitability will determine whether you will live well or have to get by frugally. If you aim to sell the business, it will determine how high a price you can secure from a buyer.
Business profitability is not a function of the size of your revenues. Generating sales alone won’t bring you profits. Sales only lead to profits if you’ve designed your business processes to be efficient and you keep a tight grip on your costs and your cash flow.
The process of building efficiency into your business is something you need to work on constantly. It needs the same continuous attention you give to winning new customers. If you let your efficiency slip, your hard work on marketing and sales could go to waste.
There are many different ways that a company can improve its profitability. The best options depend on the circumstances of your particular business. In this article I’ve summarised the most common techniques so you can try out the ones that are most likely to work well for you:
Make sure you’re working with good quality management information
When you’re trying to improve profitability, careful analysis of accurate, relevant and timely data from your business can help you identify opportunities for improvement.
The first step is to make sure you’re working from good quality cost and margin reports.
For example, check that all your costs are being entered into your accounting system under the right cost categories. This sounds obvious but it’s surprising how often items are mis-coded.
Once you’ve done that, make sure you’re analysing your cost and margin data in ways that are relevant and insightful. Use charts to illustrate your data graphically — this makes it easier to identify trends and anomalies which you can then investigate.
For example:
If many of your cost categories should rise gradually over time, plot them to see if that’s what’s happening. If a cost caption has increased sharply in the last three months, this should prompt you to investigate why.
If there should be a steady relationship between two cost items, plot them to check. For example, if the overhead costs in a department normally vary with the number of employees but the cost per employee has recently increased, check why this is happening. Perhaps a staff member left but nobody thought to cancel their subscriptions or their private medical insurance.
Finally, if you’re a manufacturing or a project-based business, check that your staff are allocating costs to the correct products or projects. Allocating costs incorrectly can give you a false picture of the profitability of different activities:
It could divert you from investigating margin improvement opportunities on products that look profitable but might actually be loss-making.
It could prompt you to make damaging cost cuts in an activity that is in fact very profitable.
Identify quick, easy ways to reduce costs
When companies decide they need to boost their profitability, the first tool they usually reach for is traditional cost cutting. And if you’re creative and imaginative it’s often surprising how much excess cost you can remove:
Supplier costs are a major focus area. You should regularly check the market to make sure you’re buying at the cheapest price. More complex tactics include timing your purchases to take advantage of predictable seasonal troughs in prices and taking advantage of periodic special deals from suppliers.
Think creatively about how to staff your operations efficiently. For example, using several part time employees or freelancers can sometimes be better and cheaper than employing permanent full-time staff. It can enable you to access workers with deep expertise only when you need them rather than employing generalists who have a broader range of skills but are less specialised in any of them.
Be smarter about your spending in categories like utilities (scrutinise the market and look for government support schemes) and travel (do it less often but more effectively).
Automate using technology. It’s usually more reliable and less costly than relying on manual processes.
These are just a few of the ways you can cut your business costs. For a comprehensive and detailed list, see our separate article on where to look for cost savings in your business.
Improve cash flow by making your balance sheet more efficient
After you’ve done some basic cost optimisation, your next step should be to examine whether you can improve your cash flow. This is another way of saying you should look for ways to reduce the amount of assets your business uses:
If the assets in your business grow, this absorbs more of your cash. For example, if you become less efficient at controlling your inventory or customers start paying you late and your receivables increase, your cash flow will turn more negative.
By contrast if you can reverse the trend and reduce your assets, this will release funds tied up in your business and your cash flow will improve.
For many companies, the most challenging area for cash flow is receivables:
Think more rigorously about the customers you take on, the orders you accept and the terms on which you do so. Turning down an order can feel like leaving a nice profit on the table, but a profit is worth nothing until you’ve banked the customer’s payment.
Audit your internal processes to make sure you’re eliminating self-inflicted payment delays caused by late or incorrect invoices.
Be creative about payment methods. For example, accepting card payments for some items costs you 2-3% in merchant fees but brings in the cash almost immediately and eliminates bad debt risk.
If you really need to, you may be able to release cash from receivables using invoice factoring.
Think afresh about when you re-stock your inventory and by how much. It might make sense to order in smaller quantities for a temporary period and accept higher unit costs if it means you conserve cash and get through a difficult trading period. Use inventory forecasting software if your purchasing volumes are large enough to justify the expense.
Delaying non-essential capex can help your cash flow a lot in the near term, although you need to be careful not to undermine the competitiveness of your business by allowing your production equipment or your IT to become technologically obsolete.
Switching to asset leasing can also deliver a significant one-off improvement in your cash position, albeit at the expense of higher recurring cash lease payments in the future.
These are a few tips on optimising cash flow to get you started. For more ideas, see our in-depth article covering ways to increase business cash flow.
Consider implementing zero-based budgeting
You may by now have investigated all the traditional ways you can think of to cut your business costs and slim your balance sheet and found that it’s not enough to deliver an attractive level of profitability. Yet you’re sure there must be scope to do more.
If so, it could be time to try out zero-based budgeting. This involves creating a new budget for your main spending categories from scratch every year. At the start of each annual budgeting cycle, managers are asked to justify all their proposed spending for the following year.
That contrasts with traditional budgeting, where next year’s planned expenses are largely based on spending in the prior year plus an adjustment for inflation, business growth or other factors.
Zero-based budgeting can be applied to any costs — SG&A expenses, direct overheads and even supplier procurement costs. It can also be applied to capital expenditures.
The technique has a number of points to recommend it. For example:
All planned costs are scrutinised, not just the increase in spending versus last year.
The technique tends to foster a culture of continuous cost discipline.
It encourages managers to be agile and flexible instead of simply replicating past practices.
There are also some downsides though:
Zero-based budgeting is more time-consuming than traditional budgeting.
It can result in short-term thinking to the detriment of long-term growth initiatives.
It can aggravate cultural or behavioural problems (e.g., tensions between managers).
Bearing those factors in mind, the technique can be appropriate in the following environments:
Organisations that are active in dynamically-changing industries, benefit from collegial cultures and are run by managers who are open to making swift strategy pivots.
Companies with poor cost discipline and an obstructive culture that need shaking up.
It might work less well in these circumstances:
Well-managed companies in stable industries where the extra time absorbed relative to traditional budgeting would not generate commensurate cost savings.
Otherwise respectable businesses where the top managers would struggle to adapt to the more dynamic requirements of the process.
See our separate article for a more comprehensive explanation of the advantages and disadvantages of zero-based budgeting.
Fundamentally redesign your processes to eliminate waste and inefficiency
The ideas I’ve discussed so far for cutting your costs and shrinking your balance sheet don’t involve any radical re-thinking of your business processes. They largely take your existing processes as a given and look for ways to execute them at lower cost or with less use of your capital.
This approach can yield large savings, especially if you haven’t done a top-to-bottom cost review for some time. But once you’ve cut costs as far as you can, you shouldn’t consider your job done. There may be significant further scope to make your business more efficient by taking on board completely fresh ideas about how to design your business processes.
A great place to look for those fresh ideas is ‘Lean’. It’s a philosophy and set of techniques that was exploited with great success in post-War Japan by manufacturing giants like Toyota. Lean has since spread outside manufacturing to service industries and the government sector right around the world.
In contrast to conventional cost cutting, Lean seeks to cut waste and inefficiency rather than costs. The technique seeks to eliminate activities that don’t create value for customers and aren’t absolutely necessary to keep your business running smoothly. It also demands that processes are designed for zero-error quality.
But by adopting a radically different perspective to traditional cost-cutting approaches, it can uncover insights that were previously hidden and open up drastic improvements in performance.
Here are a few examples of common inefficiencies and the Lean techniques you could use to eliminate them:
Poorly organised workflows waste staff time. For example, production workers should have all the materials they need to do their job close at hand and not spend time going back and forth to fetch things (the bane of many inefficient production lines). White collar staff shouldn’t have to spend idle time waiting for spending approvals or reviews of their work by their line manager.
Automate processes wherever possible to eliminate human error. Your staff should execute manual processes by following a clearly defined company best practice every time. You should identify and completely eliminate any redundant or duplicated processes.
Design products for ease of manufacture or assembly, low total cost and high reliability. Remember that you can’t inspect quality and reliability into a product — if it’s not there already, your design or production process is wrong.
Unplanned staff turnover is extremely expensive but the costs usually go unnoticed because they largely manifest as lost productivity. Take proactive steps to retain your staff — it’s nearly always cheaper than having to replace them.
Make sure your staff incentive systems are joined up and coherent. Above all, don’t aim to optimise the performance of individual teams. It’s the simple option but your teams will end up pulling in different directions. Instead of that, optimise the performance of your firm in its entirety, even if that involves sacrificing the performance of some individual parts for the sake of the whole.
See our separate article on how to make your business more efficient using Lean techniques for more ideas and implementation advice.
Fund your business partly with debt
Using some debt can improve your business profitability. That’s because debt is usually a cheaper form of finance than equity.
Let’s consider the cost of borrowing of your business. Let’s assume for this purpose that you can borrow from your bank at 10%. Let’s also assume that your business is profitable. That means you will be paying a UK corporation tax rate of between 19% (for micro enterprises) and 25% (if you make annual profits of more than £250k).
The formula for calculating a company’s cost of debt after taxation is:
After-tax cost of debt = Cost of debt x (1 – Tax rate)
On that basis, the after-tax cost of your debts would range between 7.5% (for a 25% corporate tax rate) and 8.1% (for a 19% rate).
Here’s a useful rule to remember. As long as your business is earning a rate of return on the equity invested in it that is higher than the after tax cost it would pay on any borrowings, adding some debt to your company’s funding mix will increase its Return on Equity.
Return on Equity (RoE for short) is the ratio that expresses the amount of net profit your company earns relative to the amount of equity that’s tied up in the business. It’s calculated by dividing your net profit by your equity shareholders’ funds and expressing the result as a percentage. It’s probably the most crucial measure of company profitability you need to be on top of.
Here’s a worked example that shows you how two otherwise identical companies earn different levels of RoE because one funds itself entirely with equity while the other one uses debt to fill part of its financing needs:
The first has an RoE of 15% based on £1,000k of equity shareholders’ funds and £150k of net profit.
The second is able to generate an RoE of 17% because only 80% of its £1,000k funding comes from equity and the other 20% comes from debt costing 7.5% after tax.
Note that Company B earns a lower absolute amount of net profit than Company A (£135k vs £150k) because of its interest payments. However, the owners of Company B have avoided investing £200k of equity capital into the business. They are instead able to put that money to work elsewhere.
If they can deploy this £200k in a way that earns more than 7.5% after tax (being the cost of the debt their company has taken on), they will be better off overall than if the money were invested in their business.
To summarise:
Funding your company partly with debt can increase your profitability. If your company’s RoE is higher than its cost of debt (after tax), increasing the share of your company’s funding that comes from debt rather than equity will increase your RoE, all else being equal.
Whether it’s a good idea to fund your business partly with debt doesn’t only depend on whether it increases your company’s profitability. For example, loan interest is a fixed cost that your business can’t delay paying, so this adds an extra element of risk. You need to take any debt funding decision in the round, considering all relevant factors.
If you decide in favour of adding some debt to the funding mix of your business, you would then need to consider the different options for raising funds. There are quite a lot of options to choose from so you would need to pick the right one for your circumstances.
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