You’ve just reviewed your latest financial results and realised the profit margin you achieved was lower than expected. That’s making you have to work harder to achieve your goals. What caused this? Below are 6 of the most common reasons why your business is not making the expected profits:

Incorrect pricing calculations

Assume you want your business to make a 20% profit margin. The costs to produce a product are £500. Which sales price would create a 20% profit margin?

  1. £600
  2. £625

The answer is B. 

A sales price of £600 only achieves a 16.67% profit margin, however many business owners would choose option A, reducing the profit margins they can achieve straight away. As pricing has the biggest impact on profit margins, this is a bad start!

Delaying price increases

If you find that your business costs have increased, or that your pricing has previously been too low, then price increases are required to improve your profit margins. Business owners can be scared of losing customers, so decide not to implement the increases.

What many business owners forget is that increasing pricing has a bigger influence over profit margins than higher sales or reducing costs. Look at the scenarios below which show the impacts of 1% amendments across these categories:

 STANDARD1% PRICE INCREASE1% SALES INCREASE1% VARIABLE COST REDUCTION
Sales Volume
500500505500
Sales Price£100£101£100£100
Turnover£50,000£50,500£50,500£50,000
Variable Costs(£20,000)(£20,000)(£20,200)(£19,800)
Fixed Costs(£10,000)(£10,000)(£10,000)(£10,000)
Total Costs(£30,000)(£30,000)(£30,200)(£29,800)
Profit£20,000£20,500£20,300£20,200
Profit Margin40.0%40.6%40.2%40.4%

If substantial price increases are passed on to customers, then there is a risk that you may lose some customers, but if a smaller percentage leave than the price increase you are passing on, then overall your profit margins will increase. The main point if doing this is to explain the value your customers get from your product/service and how it is different from your competitors.

Price discounting

Your customers are looking for the best value for money they can get. For this reason you are often being asked if there are any discounts available. Do you normally offer a discount just to make the sale?

Using the first example above, if you offered a 10% discount on the sales price of £625, the new price would be £562.50. The revised profit would be £62.50, which achieves a profit margin of 11.1%, a decrease of 8.9% from the previous 20% margin. That nearly halved the profits made!

Discounting can be a useful tool for businesses (i.e. to achieve bulk sales), but you should be aware of the financial impacts to ensure you are making the right decision for your business.

Not knowing your business financials

Do you regularly monitor your profit margins, at a high level, and also by product/service or customer? If you don’t, how are you going to get the data to identify how to improve your margins? Are you currently focusing on the wrong areas of your business?

Tracking these numbers will identify ways to improve your profits. For example, you can focus attention on generating sales for your products/services which achieve higher margins, or upselling to your most profitable customers. Having this data enables you to create and implement a clear strategy. Without it how will you know your business is not making the expected profits?

It’s also worth obtaining industry data, to understand if your profit margins are higher or lower than your competitors. This may be influenced on how you are competing (i.e. competing on price may mean your margins are on the lower side). This provides guidance on whether you are achieving suitable margins.

Inefficiency

Business inefficiency and waste creates unnecessary costs which reduce your margins. This can include the following:

  • Stock (obsolete stock, inefficient purchasing, wastage & defects)
  • Staffing (under utilisation of available staff)
  • Purchasing of goods/services not important to your business or customers

Having plans and processes to control and minimise these occurrences improves your profit margins.

Focusing on cash instead of profits

Some business owners base their profit calculations based on their business bank balance. You should be using your profit & loss reports, because the cash position may not consider the following:

  • staff & suppliers not yet paid
  • tax payments due
  • cash from previous year’s profits
  • advance payments from your customers

 

To survive in the long-term a business needs to be profitable, and to achieve your financial goals you need to ensure your business is hitting its profit margin targets. Knowing where and how your profits are made is vital for your business. Without this knowledge it is difficult to steer your business to future profit growth, and increasing returns for your business and yourself. Being able to react quickly when your business is not making the expected profits gives you the greatest chance of achieving your financial goals.

If you require help identifying or improving your profit margins, or any part time Finance Director support, contact Paul at Enrich Accounting here, at paul@enrichaccounting.co.uk or on 07403 407455.