Ways to make your business more profitable

The four factors that affect your profit

If you’re looking for ways to increase your profitability then you have to focus your attention on the four profit determining factors: price, sales volume, variable costs and fixed costs.

Let’s look at each of these four factors under three headings – what factor, what possible action you could take, and what conditions would have to occur. It’s important to note that profitability can be increased by either taking action to increase or decrease any of the four factors, as long as the required conditions are met.

1: Price

Increase:
Either: (1) no change in sales volume or (2) if sales volume declines, the decline is more than offset by the increase in price so that the total revenue is still increased.

Decrease:
Sales volume increases sufficiently to compensate for the decline in price and/or new customers are won who will be retained in the future as and when price is increased to normal.

2: Sales Volume

Increase
Price remains constant so the increase in volume translates into higher gross profit.

Decrease
A saving in fixed costs is achieved by reducing the size of the business and the saving is greater than the reduction in gross profit.

3: Variable Costs

Decrease
No change in product or service quality which could have a consequential effect on sales.

Increase
Improvement in product or service quality allows a higher price to be charged which is both accepted by the market and which is sufficient to offset the higher variable cost.

4: Fixed Costs

Decrease
Sales remain either (1) unchanged or (2) if they decline, the fall in gross profit is less than the decline in fixed costs.

Increase
Sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs.

Things To Take Note of

The first interesting thing to notice about the above summary is that no single factor can be considered in isolation without considering its impact on, or the impact from each of the other three factors.

The second thing to remember is that a profit improvement strategy may involve either an increase or decrease in each of the four factors. There is no standard success formula, it depends entirely on specific circumstances and the relative strengths and weaknesses of your business.

The third thing to notice is that a favourable change in price and/or your variable costs will improve your gross margin per dollar of sales. Whereas a favourable change in your sales volume and/or your fixed costs indicates greater productivity. That is, the overheads you incur in running your business are lower per dollar of sales.

In other words any profit improvement strategy must focus on either or both of two things:

1. achieving a higher gross margin per dollar of sales by increasing price and/or reducing variable costs.
   and/or

2. achieving greater sales per dollar of fixed costs by increasing the productivity of those things which have a fixed cost.

So that we can put everything into some sort of perspective let’s consider the profit improvement potential that would arise from a modest improvement in each of the four factors. Let’s consider the case of a 5% improvement in each of the four factors:

                                                 Base                       Change                       Result
Price                                           100                      5% increase                     105
Sales Volume                             100                      5% increase                     105
Total Revenue                       10,000                                                           11,025
Variable Costs ($60)              6,000                      5% decrease ($57)     5,985
Gross Margin                           4,000                                                             5,040
Fixed Costs                              3,000                      5% decrease                 2,850
Net Profit                               $1,000                                                            $2,190

It can be seen that a 5% favourable change in each of the four factors without a consequential unfavourable impact on each of the other three would more than double your profit from $1,000 to $2,190. This is a 119% improvement!

You may want to take issue with the assumption that there are no consequential impacts. However, it is a fact that small improvements made to each of the four factors that determine your profit will combine to give a staggering overall impact. And, of course, the reverse is also true. If you discount your price, allow your sales volume to fall, fail to control your overhead costs and let your variable costs get away from you then you can destroy a potentially profitable business. This can happen very quickly.

You see it’s all to do with leverage and this is what brings so many people unstuck. If you get all the little things right, the big picture looks after itself. But if you get all the little things wrong you’re going to be in real trouble and it’s likely you’ll never know why.