Brian owned a successful manufacturing business with sales of $15 million per year who had recently noticed a large slip in its profit margins.
At the time Brian first joined our business coaching program his operating profit margin formula (pre-tax profit from actual operations) had slipped to under 3%.
They were behind on their key contracts, forcing them to pay large dollars to expedite shipments, and their manufacturing processes had grown sloppy causing excessive scrap costs.
In a moment I’ll share the concrete suggestions that have helped Brian and his company triple their operating profits over the past 5 years since we first began our work together. Before we dive in, I want to ask you if you feel like your margins are what they should be based on your industry and business model?
In order for you to serve your customers, pay your employees, and reward your investors (yourself or outside investors), your business must be profitable. Your margins are a measurement of your company’s profitability.
There are two “margins” that the owner must focus on.
The first and most easily understood is your “operating profit margin.” This number is simply a calculation of how much of every dollar in sales ends up as operating profit (pretax) for your business.
For example, if you had $10 million in sales and ended up with a pretax profit of $2,500,000, your operating profit margin would be 25 percent. Your operating profit margin is a great measure of how profitable your business is overall.
Building on our fictitious $10 million-per-year company, if you were able to go from a 25 percent to a 30 percent margin by better managing your operating expenses, you’d earn $500,000 more profit from that same $10 million of gross revenue.
That 5 percent increase in operating profit margin equals a 20 percent increase in profit.
Don’t worry about the math too closely; what matters is to get a feel for the concept of your operating profit margin and why it matters to your business.
The second margin you need to understand is your “gross profit margin”. This is perhaps the most misunderstood and least leveraged number in your business.
Your gross margin is a measure of how much money you have left over from every sale after you take out what it cost you to produce or acquire the product or service you just sold.
It’s calculated as follows: Gross Sales (i.e., total sales before any operating expenses) less COGS (the “cost of goods sold” for the sales you made)
In my experience, the gross margin is the most underutilized, most misunderstood margin in most businesses. Yet it is such a powerful number.
It tells you exactly how much money you have left after you pay the direct cost to produce and fulfill on a sale to spend on marketing, sales, fixed overhead, and so on—and still have enough left to make a reasonable profit for your time, effort, and risk.
This number is also a great indicator of the overall efficiency of your business.
Knowing this number helps you look strategically at your pricing. It lets you know which customers, products, or projects are the best margin business to go after, and which you should consider phasing out (or even immediately cutting), and it even helps you spot inefficiencies in your production.
Here are five concrete tips to help you improve profit margin over the long term:
- Velocity matters. The faster your turnaround time (from order to delivery), the lower your overhead cost per unit produced. This in turn means improved profit margins.
So go back to your main systems from order to delivery, how can you speed up the process? Are there steps you can eliminate? Ways to shorten parts of the process? Can you automate, template, or pre-do steps? Can you script out your linkages between people and departments to speed up the process? Remember, the faster you make this cycle, the better your company’s profit margins will be, all things being equal.
- Up-sell and cross-sell to increase your average unit of sale. In general, when you increase the amount you sell to your customer at one time, you’ll improve your margins because you’ll be increasing the purchase velocity and therefore lowering your direct cost per sale in terms of overhead burden.
So how can you increase your average unit of sale per customer? Can you up-sell to richer offerings? Can you offer larger units of purchase? Can you cross sell complimentary products or services? All of this allows you to amortize your marketing cost over a larger unit of sale which will dilute your marketing cost for each sale and hence increase gross profit margin.
- Cut low margin clients, products, or services, and invest the saved time and money in higher-producing parts of your business. This presupposes that you have accurate and timely reporting that shows you which one out of the three produce what margins.
Assuming that you do, review a “margin analysis” of your key products, services or customers to see which are most and least profitable. One CPA firm we helped do this discovered that their best one-third of clients were covering their operating costs for their bottom third of clients who due to “scope creep” in their monthly write-up work were actually negative margin clients (i.e. these bottom third clients were costing them money every month to have them as clients!)
- Customer retention and attrition costs. Do all you can to keep your clients actively purchasing from you. Study the most common “drop points” in your client’s purchase history.
Can you strategically reinforce your business system to reduce that attrition? Perhaps you need to better communicate with them how to use your product or service? Perhaps give them a well-timed “gift” or make a well-timed visit or phone call? Courting your current customers eliminates or greatly reduces the acquisition or marketing cost on that second and all later transactions.
- Watch out for scrap, spoilage, and wastage. Is it a quality issue on production? Are you poor at forecasting, and keep too much supply on hand for an order? Does it take you too long to sell your inventory and you lose part of it to obsolescence?
This can also be an issue in areas of your business outside of operations, for example buying leads that your sales team can’t or doesn’t follow up with or investing in marketing that doesn’t work.
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