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Understanding profitability

Like many owners of small businesses, you probably started your company because you had an idea, saw a gap in the market, or thought that working for yourself would be 100 times better than working in the corporate world. A high proportion of business owners have not received any financial or accountancy training but to ensure the business continues to trade in the long term, it is important to understand a few key financial principles. One of these is understanding profitability and what drives that profitability. This is particularly true at the moment as costs spiral and margins are squeezed, but what does that mean? And what can you do about it?

Over many years of helping business owners to understand finance, we have discovered that most of our clients know what profit is:

It’s how much money your business makes after you have deducted costs and expenses. It is an outcome that results from all the effort and activity running the business.

However, many have difficulty understanding how to influence profitability, which is not quitethe same thing:

Understanding profitability comes from an awareness of the things you do in the business and how that affects the outcome, even though it may not be immediately obvious. This is what financial people refer to as cost drivers.

Understanding profitability and margins are a tool to help measure the efficiency and effectiveness of your company, so it is important to understand how it can be affected and how you can use forecasting and business planning to make sure your cover all the bases. In this blog, we are going to explore how some factors affect profitability, things you may not have taken into account when initially starting your business.

Some examples of costs that can really impact margins and may not be immediately obvious are:

  1. Recall/Return/Replacement
  2. Overservicing

Recall/Return/Replacement of goods

Any business making/selling goods has to consider the impact of product returns. This can be a formal product recall (ranging in cause from  a defect or a safety issue) through to the more common return as a result of customer or consumer choice.

Although the decision for a formal recall is normally made by the manufacturer, it could also be imposed by an industry regulator (Trading Standards for example.)

There are direct costs of a product recall all of which would impact profitability:

  • Getting the product back
  • Storage of returned goods
  • Testing the returned goods to determine the fault and percentage of occurrences
  • Scrapping of products that cannot be repaired and resold, and their destruction
  • Cost of sending replacement products
  • Interruption to normal manufacturing processes and additional labour costs
  • Refunds and cost of transporting faulty goods

Another action that can affect the normal running of your business is notifying interested parties:

  • Your supply chain
  • Consumers of your product worldwide (e.g. advertising costs)
  • Industry regulators/trading standards/safety executive etc.

The financial costs and the effect on profitability to your business of a product recall can go way beyond recall and refund:

  • Ongoing cost to your company’s reputation
  • Court cases/Fines
  • Inability to attract investors 
  • Production stoppage/redesign costs/review of processes
  • Supply chain/retailer trust

The good news is that you can take steps that will help to mitigate product recall/replacement costs:

  • Make sure management teams knows the industry safety standards/regulations
  • Allocate resources to comply with regulations
  • Robust and consistent in-house training
  • Make safety a business priority
  • Establish quality procedures/controls for your business and your suppliers
  • Undertake regular audits, preferably by an independent auditor
  • Maintain good records to allow traceability
  • Have a plan in place for handling a product recall
  • Insure your company against such an event

The more commonplace returns from customers can also be a huge cost to a business:

  • Administration time and effort
  • Packaging/re-packaging
  • The ultimate price that can be achieved for sale of returned goods

It is therefore vital to factor assumptions on the volume and cost of returns into your financial planning to truly understand profitability.

For businesses that supply services, there can still be a re-work cost if the scope of the service isn’t properly agreed up front.

You will find more tips on how to reduce the impact of returned products on the profitability of your company here. Link to : https://www.netsuite.com/portal/resource/articles/inventory-management/4-ways-to-minimize-the-impact-of-returns-on-profitability.shtml

We realise that this is a lot to take in and to plan for, but at Mellor Financial Management, we can cut out the jargon to show you how financial planning can help you to make complicated business decisions. Why not call us to discuss your requirements and make the most of our expertise gained from 20+ years as senior management specialists?

Overservicing

In today’s economy, every business owner is afraid of a bad review and the knock-on effects on company reputation and future business. But there is a big difference between offering good service and going that extra mile, and a tendency to overservice clients.

For example, if you own an electrical contracting business, your employees may go that extra mile by cleaning up after the job or showing the customer how their new installation works – this costs nothing in materials, just a little time and is good customer service. On the other hand, if they installed six plug points when you only quoted for four, that is overservicing and crucially, not a service you have priced/charged for.

Overservicing can result from a number of different factors, for example:

  • A client with too small a budget for the job
  • Adding work that wasn’t included in the quote and isn’t billed
  • The desire to impress a new client by including extra unpaid work
  • Filling time when the business is quiet

Do you recognise some of these traits? Any work that is undertaken but not paid for can be classed as overservicing, and this has a direct effect on the profit margin for each job. But it can also affect your ability to make profits in the future, for example if it becomes normal practice, or if your customers come to expect it, but at a price point that doesn’t reflect the service provided.

The key here is to make sure you/your employees stick to the contract or only doing the job you have quoted for. If you want to offer extras, add them as priced options, so your customers know these are additional to the quoted job. You can learn more about the problems of overservicing here. Link to: https://www.thejoyofbusiness.co.uk/how/weaning-yourself-off-overservicing-clients/

Financial planning

I have met a lot of business owners over the years, who looked at me quite blankly when I asked whether they have a financial plan in place. But financial planning will help you to make better informed decisions about allocating resources in the right place at the right time within your business. Doing a financial plan at the beginning of the year can help to identify problem areas like the ones outlined in this blog and can also form the basis of targets for the year ahead. A good plan includes both a cash flow forecast, and a profit and loss statement. The plan provides you with an overall picture on which to base business decisions, test out scenarios, and sensitivity to help understand the profitability of your business and budget wisely. At a time when many costs are increasing, for example utilities and employment related costs, this puts an added onus on understanding profitability.

If you need to cut through the jargon and get some expert support or advice about financial planning, understanding profitability, and how cloud accounting platforms can help your small business, please get in touch.

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