Blog

Maximizing Profits in your Business – Profit Fundamentals and Analysis

April 23, 2010 by Frank Goley, Business Consultant

This post will show the business owner how to understand and analyze an Income and Expense Statement and perform Profit Analysis. Having a good Business Plan in place to successfully run your business is important but implementation of that Plan is necessary to reap its benefits. One aspect of implementing your Business Plan into your Company’s Operations is through good Income Statement Analysis, Planning and Application.  As your Strategic Plan tracks and implements your Profitable Operations, it is important to understand what your Income Statement is telling you, how to realistically project your future profit potential and how to effectively maximize Company Profits. 

I.        Income Statement Fundamentals 

Let’s first understand what is in an Income Statement and what the various components of it represent.  Note:  I am using a Manufacturing Company as an example. 

A.    Major Components of an Income Statement: 

1.     Sales and Revenue

2.     Cost of Goods Sold / Cost of Sales (COGS)

a.     Material

b.    Direct Labor

c.     Manufacturing or Factory Overhead

3.     Operating or Gross Margin (GM)

4.     Expenses

a.     Engineering

b.    Marketing

c.     General and Administrative (G & A)

5.     Pre-Tax Profit

B.    Revenue / Sales:

1.     Breakdown of all Products and Services and the resulting Revenue for each category. 

2.     Last Line should be the overall average:  Units sold times the Average Unit Price.

C.    Cost of Goods Sold / Cost of Sales:

1.     Cost of providing a product or service for sale.

2.     In a manufacturing company it comprises of:

a.     Material:  Raw material and parts required to build a unit.  A significant part of each Revenue Dollar, i.e.  40% of each sales dollar on new equipment and 15% for spare parts. 

b.    Direct Labor:  Labor cost in manufacturing a product.  Typically, 7 cents of each Revenue Dollar for new equipment and 1.5 cents for spare parts. Note: Material and Direct Labor costs are Variable, varying directly to the quantity produced. 

c.     Manufacturing or Factory Overhead:  Costs which don’t contribute directly to the production but necessary to build a product.  For example, Employees of the Purchasing Department, Material and Production Control Planners, Clerks, Quality Assurance Inspectors, Manufacturing Department Personnel, etc. Note:  Overhead is a Fixed Expense, not fluctuating appreciably with output. 

D.    Operating Margin: 

Sales minus Cost of Goods Sold

E.    Expenses:

1.     Engineering

2.     Marketing:  Usually the highest expense.

3.     General & Administrative:  Usually the smallest expense.

F.    Pre-Tax Profit: 

Operating (Gross) Margin minus Expenses 

II.        Maximizing Profit Analysis

A.    Market Analysis and Marketing Plan:

1.     Must have an accurate Analysis to determine what the Market is willing to pay. 

2.     Understand clearly your Competitor’s pricing and develop a successful Pricing Strategy for your Marketing Plan. 

3.     Price War Considerations: 

a.     Pricing below your Competitor’s pricing may go too far and set off a Price War. 

b.    Competitors respond by reducing prices below market values to recapture market share lost. 

c.     Customers can become accustomed to the lower fair-value price, making it hard to return to pre-war pricing.  Gross Margins of a profitable 50% can quickly erode to the breakeven point, typically about 30%. 

d.    An Accurate Market Analysis and an effectively implemented Marketing Plan understands both the Customers and Competitors responses to certain price levels. 

B.    After Market Sales:  Spare Parts 

1.     Most profitable product line:  70% Gross Margin (GM), representing about 12% of Sales Revenue. 

2.     Cost of Goods (COGS) on Spare Parts is normally about 30 cents of each Sales Dollar when operating with a 70% Gross Margin. 

a.     COGS on new equipment represent about 60 cents of each Sales Dollar and a resulting 40% GM. 

3.     Key:  Keep a high ratio of spare parts to new equipment for Maximum Profits. 

a.     Package Spare Parts when you sell New Equipment with a GM range of 70-95% on the various parts, discounting the New Equipment. 

C.    Cost of Materials: 

1.     Although Materials (all the parts, components and sub-assemblies of a product) is a cost that is fixed on a per unit basis, it can be manipulated for maximum profit potential. 

a.     Material for a manufacturing company typically represents about 38 cents of each sales dollar for new equipment and about 1.5 cents per sales dollar for spare parts, for a total average of about 39.5 cents per sales dollar. 

2.     Value Engineering:  Designing and re-designing products for the lowest cost without performance compromises. 

a.     Each part and sub-assembly is analyzed to determine if comparable function can be achieved at lower costs by utilizing different materials, components, manufacturing processes or lower cost vendors.

i.        An example would be adjusting a component’s tolerance from 5% to 10%, provided the design analysis finds the substitution acceptable.    

 ii.      Simply cleaning a part during the machining or assembly steps can lower costs. b.    Examine production procedures to reduce waste and spoilage. 

3.     Raw Material Management:  Strongly contingent on good Market Planning & Forecasting.  If the forecast is too optimistic, then too much material is purchased, which unnecessarily raises inventory costs.  If the forecast is too conservative or too low, then too little material is procured, which can result in late product delivery, customer dissatisfaction and lost sales, which in turn causes an increase in effective material costs. 

4.     Inventory Management: 

a.     Minimize costs through volume purchase agreements with suppliers.                       

 i.        Contract with a supplier to buy a maximum number of parts over a fixed period, normally 1-2 years.         

 ii.        The buyer stipulates minimum and maximum monthly quantity limits in its purchase order, which allows the buyer to adjust inventory levels within the set range and to known production requirements at the time.          

iii.        Again this system only works well when the Marketing Forecast is accurate within reasonable levels.                          

  iv.        This also helps suppliers as they can optimally adjust their inventory and labor levels, which enables them to pass savings on to the buyer as discounts.                                           

v.        Bill-Back Clause Protections for the supplier:  Protects the supplier if the Buyer doesn’t meet the minimum purchase level and/ or puts a premium or extra discount on purchases exceeding the maximum agreed level. b.    Use an integrated Computer Software Program, customized to your Company which tracks, manages, budgets and forecasts your Raw Material and Inventory needs.  This system needs to be carefully integrated with your Marketing Department. 

5.     Good Relationship with Suppliers: 

a.     Suppliers experiencing low capacity offer better discounts.

b.    Suppliers can suggest different methods, processes, materials or manufacturing tolerances to help you save money. 

c.     Pay your bills early or on time to receive Supplier incentive discounts.  Late payments will result in higher cots being levied in the future. 

d.    Have excellent communication lines established with your Suppliers which can be very helpful when you hit a downturn in sales and find meeting obligations difficult. 

e.     Develop a Supplier Business Plan. 

D.    Direct Labor Cost Savings Strategies 

1.     Direct Labor on average for a manufacturing company should cost about 9 cents of each sales dollar; of this cost, new equipment is 7 cents and spare parts is 2 cents. 

2.     Keep personnel turnover low, which reduces training costs. 

a.     Skilled, trained labor can accomplish the same task at a lower cost, with fewer errors, along with, better efficiency & productivity. 

b.    Proactive Employee Incentives is much more effective than trying to retain employees through fear tactics. 

c.     Provide good working conditions and don’t overwork your experienced employees.  Use temporary or flex workers for short-term production gear ups and upturns. 

3.     Locate production facilities in less expensive parts of the region which offer tax incentives and lower labor costs for highly skilled laborers. 

E.    Manufacturing Overhead Cost Savings 

1.     The key in this area is Management Control.  Overhead typically accounts for about 14 cents per sales dollar. 

2.     Good Control Mechanisms executed from the outset can keep costs in check without Budget cutting. 

3.     Overhead Cost Management is divided into three areas: 

a.     Facilities, Communications & Data Management 

b.    Indirect Labor 

c.     Operating Expenses 

4.     Facilities:  Immediate space requirements should have expansion options which meet your Company’s Strategic Plan Goals. 

a.     Ensure your Facility is designed to minimize utility costs and located in an area which has reasonable utility rates. 

5.     Communications:  Bundle your communication needs into a package for maximum cost minimization, better company integration and superior operating results. 

a.     Bundle your communications with a Company that offers excellent customer service as that keeps expensive down-time to a minimum. 

b.    Bundle a maintenance contract with your Communications package to minimize long-term costs. 

6.     Data Management:  Utilize a Consulting Firm to customize a Data Management system to your Company’s products and operations.  This should be carefully linked to the Marketing and Strategic Planning Departments, while also fully integrated into the Company’s procurement, inventory, sales and operations areas. 

7.     Indirect Labor:  Typically the second largest expense of operations departments in manufacturing companies.  This is an area where maximum Control can be utilized. a.     Weigh the costs of trained labor verses inexpensive labor and determine a cost effective, yet productive mix of the two. b.    Utilize strict employment level management.  Indiscriminate hiring and firing has detrimental long-term effects. c.     Foster strong Employee communications, mutual trust and relations, which ensures efficiencies and lower overall labor costs.  

8.     Operating Expenses:  The least expensive operational category for a manufacturing concern. 

a.     The key here is avoiding waste. 

b.    Satisfied employees, who understand how waste negatively affects their pay and benefits through lower productivity and higher per unit costs, will reciprocate in adhering to Waste Management Procedures. 

F.    Cost of Goods Sold (COGS) 

1.     Understand that COGS is the sum of Materials, Labor and Overhead.  COGS can amount up to 61% of each sales dollar, so just 1% saved here can make a significant impact on Pre-Tax Profits. 

G.    Gross Margin (GM) 

1.     The difference between Sales and COGS.  For a Manufacturing Company, a good target goal is 50% GM, as break-even is often in the 25-30% range.  While 50% GM can be a difficult goal, ensure you have at least a 10% cushion between GM and Break-Even to ensure profitable operations during slow periods or unpredictable circumstances. 

2.     How do you maximize GM? 

a.     Effectively managing your Company’s Engineering Costs and G&A expenses. 

b.    Realistic and integrated Market Planning. 

c.     Any costs minimized in Engineering, Marketing and G&A adds significantly and directly to Pre-Tax Profits. 

3.     Manage Engineering Costs: 

a.     Consider Engineering as an Investment and should be integrated closely with your Company’s Strategic Plan.  The most expensive cost initially, stabilizing to @ 9 cents per sales dollar. 

b.    Accurate Statement of Work:  Engineering Manager divides each project/ product into components of skill, time, skill hours, labor requirements, labor costs, benefits costs, supply costs, material costs and so forth. 

c.     You cannot manage costs until they are broken down, identified and quantified. 

d.    Engineering Cost Management should be closely aligned with the Strategic Planning Department’s Budgeting Process and Controls in order to fully maximize cost reductions in this area. 

4.     Marketing Expenses:  Generally the highest of the three Expense Categories for Manufacturing Companies.  10 cents per sales dollar is typical for a stabilized Manufacturing Company. 

a.     Areas to Analyze:  Salaries and commissions of sales people; manufacturing reps commissions; product managers salaries; service and administrative personnel salaries; advertising and travel costs; communication costs; supply costs. 

b.    Understand how Bonuses and Incentives can significantly increase the productivity value of your Marketing Expense bottom line. 

5.     General and  Administrative Expenses (G&A):  Typically the least expensive expense category for a manufacturing company.  7 cents of each sales dollar is a good goal. 

a.     Components Include:  CEO, Executives, Finance, Accounting, Personnel and Support Staff. 

b.    Primary expense item in this category are salaries, so Competitive Salary Structures should be monitored regularly to ensure the 7% goal is maintained. 

6.     Total Expenses:  For a manufacturing company, total Expenses normally account for 25 cents of each sales dollar.  The remainder is Pre-Tax Profit, which should typically be in the 15% range or 15 cents per sales dollar. 

H.    Pre-Tax Profit: 

Pre-Tax Profits can only be effectively maximized through a step by step Analysis of a Company’s Income Statement, ensuring it is closely aligned with a Company’s Income Statement, ensuring it is closely aligned with a Company’s Marketing Analysis, Marketing Plan and Strategic Planning.  The resulting strategy will significantly minimize Expenses, which has a direct effect on Pre-Tax Profits.  This should be a comprehensive, cumulative approach in order to achieve maximum Profitability. 

I.      After-Tax Profits: 

In a 30% tax bracket, after-tax profit is 10.5% or 10.5 cents per sales dollar. 

1.     Higher or lower resulting tax brackets can significantly affect After-Tax Profits, so utilizing an Accounting and Tax Firm specializing in your business is highly important. 

2.     Average after-tax profit for Manufacturing Companies runs about 5%. 

3.     After-Tax Profits are vital to a Company’s Growth and Investment, resulting in more Retained Earnings and higher Cash Flows and needed when opportunities arise in the market. 

4.     Cash Accumulation allows for better leverage and terms when negotiating funding to expand and grow your Company. 

J.     Summation of Components: 

The Income Statement Analysis illustrates how sales dollars are distributed and how to minimize costs in order to maximize profits.  Central to this step by step, cumulative Analysis is to determine how each Income Statement Component’s percentage of cost contributes to the Sum Total, as adjusting each component has an exponential effect on Profitability. Profits can only be maximized by clearly understanding and managing its parts.

Having discussed the Fundamentals of the Income Statement and performed a Profit Analysis, in my next post I will explain how to effectively Plan for Profits.

Posted in Business Financials.