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Profit Planning

April 26, 2010 by Frank Goley, Business Consultant

A lack of accurate Cost Estimation and Analysis results in Profits of unknown quantity and often Loss.  Some Companies who are profitable still fail.  Why?  Profits are not necessarily in the form of cash, such as Accounts Receivable, which may presently be uncollectable.  Focusing just on Net Income can be a mistake unless contingent variables are considered.  It is vital that a Company sets and monitors certain Benchmarks in its Strategic Planning from which performance can be measured and tracked.

Profit Relationships and Components

Net Income (Profit) = Revenue (Income) minus Expenses (Costs)

a.     Revenue comes in the form of Cash and Accounts Receivable.

b.    There are Two Types of Expenses:  Fixed and Variable             

 i.        Fixed Expenses:  incur periodically, regardless of operational effect and include items such as Rent, Insurance and Depreciation.            

ii.        Variable Expenses:  Vary according to the level of Operations.  This includes items such as Product Labor and Material, Sales Promotion and Cost of Delivery.

c.     Profit Expressions:             

i.        Gross Income = Net Sales minus Cost of Goods Sold (COGS)            

ii.        Operating Profit = Gross Margin           

iii.        Net Income Before Tax           

iv.        Net Income After Tax            

v.        All of the above expressions of Profitability indicate a certain relationship between Revenue and Expenses.  A decline in Profit Margin should be the catalyst to search for a cause, such as an increase in expenses; discounting or pricing errors caused a decline in per unit sales revenue; or a change in business operations.

Plan for Profit

Important Fundamentals:

a.     Liquidity provides maximum flexibility.

b.    Income Statement is viewed in relation to the Balance Sheet and the Cash Flow Statement.

c.     Managed, under control Growth leads to Planned Growth.

d.    Short and Long Range Business Planning which has clearly integrated relationships between Product Development, Market Planning, Strategic Planning and Financial Management.

Profit Planning Steps:

a.     Step 1:  Profit Goal             

i.        A target value based on the realistic, developed results of your Company’s Strategic Plan.

b.    Step 2:  Planned Sales Volume required to make the Profit Goal.             

i.        Utilize Operating and Sales Budget Forecasts            

ii.        The Forecasts influence decisions on Materials Purchasing, Production Schedules, Financial Resource Acquisition, Plant and Equipment Procurement, Personnel Enumeration, along with Employment and Inventory Planning.           

iii.        Forecasts derived from well developed, realistic determinations of Market Conditions, Market Trends, Industry Trends, Competitive Analysis, Competitive Edge, Market Segmentation, Promotion Strategies, Pricing Strategies, Distribution, Inflation and so forth.           

iv.        Sales Volume Forecasts which are achievable and accurate come from the previously prescribed development relationships between:

a)     Product Development

b)    Market Planning

c)     Strategic Planning            

v.        Picking arbitrary numbers for steps 1 and 2 will result in faulty Sales Forecasts, tainting the process from the beginning.

c.     Step 3:  Expenses Estimation for the Planned Sales Volume             

i.        Use previous years’ numbers if an existing company. For start-ups, analyze similar companies in the industry and tap published research to come up with realistic estimates of Expenses.            

ii.        Adjust Expense Projections based on:a)     Change in Economic Conditionsb)    Ratio of Expenses to Sales Level Changec)     Production Methods Improvements and Efficienciesd)    Reasonable salary levelse)     Materials to produce your goodsf)     Labor to produce your products           

iii.        Establish a Cost of Goods and compare it to the industry average for accuracy.           

iv.        Figure in expenses which vary directly with changes in Volume.

d.    Step 4:  Estimated Profit 

i.        Estimated / Projected Sales Income minus Expected Expenses.    

e.     Step 5:  Compare your Estimated Profit with your Profit Goal (step 1)

   i.        If there is a wide discrepancy between estimated profits and your profit goal, continue with the subsequent steps.

f.     Step 6:  Determine Alternatives to Improve Profits             

i.        Change Planned Sales Income:

a)     Increase Sales Promotion

b)    Improve Product Quality

c)     Improve Access to Product’s Availability

d)    Alternative Product Uses

e)     Analyze Unit Pricing Strategy to determine Best Pricing Policy for your defined Target Markets

f)     Better Service

g)    More Product Reliability

h)     More Integrity in your Sales Process

i)      Better Updating / Upgrading Strategy

j)      Better After-Market Sales Strategy             

 ii.        Decrease Planned Expenses:

a)     Better Control Systems for Product Development

b)    Minimize Losses

c)     Increased Productivity of People & Machines

d)    Product Re-Design, Re-Branding, Re-Packaging

e)     Product Improvements

f)     Cost Reduction Analysis and the resulting integrated strategy

g)    Better Budgeting Control Mechanisms           

 iii.        Reduce Unit Costs:

a)     Add other products in the mix to offset costs

b)    Using idle capacity and assets innovatively

c)     Make certain parts internally if more efficient than purchasing from Vendors

d)    Kaizen Costing:  Advance Cost Targets in all aspects of Product Design, Development and Production.  Each Company Department and Cost Center sets specific Cost Reduction Plans for each quarter.           

iv.        Subcontract Certain Work and Outsource

g.    Step 7:  Determine how Expenses vary with Sales Volume Changes             

 i.        Experiment with Expense levels in selling fewer or more units with the information obtained in Step 3, understanding the relationship of Fixed and Variable Expenses to find the optimal mix of Products and the Unit Sales of those Products.           

 ii.        Beware:

a)     Analyze Limited changes in Sales Volume as High Sales Volumes are costly and expend a lot of effort and Low Sales Volumes results in extra costs due to idle capacity, lack of volume discounts, underutilized highly trained and expensive labor force, and so on.

b)    Changing conditions:  Economic shifts, Inflation, Deflation, Customer Shifts, Competitive Products, Market Shifts and other Factors causing changes in Unit Costs.

h.     Step 8:  Understand how Profits vary with Sales Volume Changes             

i.        Use different Sales Volumes to determine the resulting Break Even Point and the Profitability Vector.

i.      Step 9:  Analyze Profit Alternatives             

i.        Using the information generated in Steps 6, 7 and 8 consider profit increasing alternatives, such as:

a)     Sales Price Changes

b)    Change Advertising / Promotion Strategy

c)     Reduce Variable Costs

d)    Increase / Decrease Quality of Products

e)     Find the right mix of Products

f)     Eliminate Low-Margin Products

g)    Bundle High Margin Spare Parts with New Equipment

j.      Step 10:  Finalize the Strategic Plan and Implement              

 i.        Measure the Strategic Plan’s implementation over time to keep track of your Company’s resulting Pre-Tax Return on Equity and Pre-Tax Profit Margin.            

ii.        Implement Tax Savings Strategies to retain more Earnings for future Opportunities and Expansion. 

In my next post, I will discuss how to apply the Profit Analysis and Planning Process.

Posted in Business Financials.