Unprofitable Growth
Q. I own a business that manufactures electrical components we sell to companies that build them into the products they make. My sales doubled last year, but we still didn’t make any money. The truth is that we are barely breaking even. Can you help me figure out what is going on?
A. The problem is that your revenue doubled, but your costs also doubled. This shouldn’t be the case. As your business grows, costs should increase more slowly than revenue so that profit compounds. We’ll suggest four places to look for your lost profit.
Product Profitability – If you don’t already, you need to understand the gross margin of each component you manufacturer (gross margin = sales price – the cost of goods sold). The cost of goods sold is everything you spend to build the components you sell. At a minimum, this will include the cost of material and labor.
You may well find that some of the components you produce have a negative gross margin. You can’t make that up in volume because you’ll be losing money on each one you sell. Negative gross margins are sometimes justified, if they allow you to sell other products that make lots of money. The often cited example is razors. You may be willing to lose money selling razors if this results in very profitable razor blade sales. However, in general you should not have negative gross margins. If you do, either increase the price or find a way to reduce the cost of the product.
In many businesses it makes sense to establish a minimum acceptable gross margin. Then price your products so that you achieve at least this gross margin. For example, if your overhead as a percentage of revenue is 20 percent, you might establish a minimum acceptable gross margin of 25 percent (gross margin % = gross margin ÷ revenue). This means that at worst you would cover your overhead and make a 5 percent profit. Since you are just breaking even, you will almost certainly have products that are not covering their share of the overhead. Look for ways to improve these gross margins.
Customer Profitability – You also need to understand the profitability of each of your customers. Most often, some customers will pay lower prices than others and some customers will cost more to serve than others. This drives different levels of profitability. You may find that some customers are unprofitable. Take steps to improve the profitability of these relationships—increase the price you charge these customers or reduce the cost to serve them. You can do the same analysis of customer profitability that we described above for product profitability. Minimum profitability goals can also be established in the same way.
We’ve done this analysis across a broad range of industries. We have often, but not always found that large customers are less profitable because they have the volume to negotiate lower prices. Small customers are frequently less profitable because they are expensive to serve. Midsize customers may be the most profitable to serve.
Overhead – As revenue grows overhead should remain relatively constant. Take a look at what happened to your overhead as your business grew. Too often small business owners let their overhead costs rise with revenue. If that is the case in your situation, cut overhead back to pre-growth levels wherever possible. We understand that some overhead costs may grow with revenue. For example, if you are sending out more invoices it will likely require more labor hours. However, many overhead costs can be held constant as revenue grows.
Cost Reduction – Does your new higher volume provide opportunities for cost reductions? Since your volume has doubled, you may be able to negotiate lower material prices. If you are sending out twice the number of invoices, perhaps the process can be automated. Volume growth provides opportunities for cost reduction. Make sure you capture these opportunities.
Too many small businesses fail to capture the economies of scale that should accrue to them as their volume increases. Following the tips above will allow you to claw back the profit you’ve missed.