DOES YOUR BUSINESS ADDUP?

Companies can grow their profits through a better understanding of the financials. Peter Hill does the math.

Let me start by admitting that I am an accountant. Not only that, but I am both a Certified and Chartered Accountant.  I like numbers and I understand them. But that doesn’t make me a dull person, honest!

What it does mean is that I understand how businesses make money, and perhaps just as importantly, where they lose it. I have presented countless seminars around the world (and virtually) on why businesses need to focus attention on the five ways to grow profits, but what I see over and over again, are businesses making decisions based on emotions and not facts.

Let’s illustrate one of the common challenges I come across, with a real-life example.

A limited company – A Ltd – was a wholesale business turning over £10m. It sold mainly business to business, but with some consumer sales over the counter. Like many of this type, it gave discounts to customers against the list price of its goods. 

When I became involved I asked how much was given away in discounts each year. The answer (in fact the answer I get from every business where I ask this question) was that it didn’t know.

The first line of its accounting information was ‘sales’, i.e. the amount of all invoices raised at the prices agreed. So after a little investigation, we found the ‘list price’ of all items sold and compared this to actual sales, and discovered that the average discount given was almost exactly 20%.

So we now know that this £10m business is actually a £12.5m business that gives away £2.5m in discounts each year. This was the second biggest cost in their business behind goods bought to sell. Bigger than payroll, bigger than all the property costs, bigger than all other running costs of the business added together. But remember, no one knew this number. It was not reported anywhere.  No one had responsibility to control it. You would find it hard to get £10 from the petty cash tin for expenses, but you could give away £1,000 in discounts with the press of a button.

So why did this happen?

When we ran sales training for this business, we encountered the typical sales attitude of “If we are more expensive we will sell less”. Therefore, the standard approach was “We need to be cheaper (give discounts) in order to sell more”. 

I get it. It is probably right at a conceptual level, but it is wrong at a practical level. The business was a 30% margin business. So something costing £70 was sold for £100 generating £30 gross profit. The sales argument was that if we charged say £90 (10% discount) we would sell more stuff. However, the business now only makes £20 profit on these items.  So 1,000 of those items used to generate £30,000 of gross profit, and we now need to sell 1,500 items to make the same amount.

So, if the business discounted prices by just 10% to drive extra sales, it needs to sell 50% more of them just to get back to where it started. That simply doesn’t happen.

So the emotional, instinctive judgement ‘be cheaper = sell more, be more expensive = sell less’, reaches the wrong conclusion in the absence of the financial reality.

Know your customers

Let’s look at another key area where facts change behaviours.

Another company – B Ltd – has a £6m business serving a wide range of customers. It has good financial information on profit margins, discounts being given and makes a healthy bottom line. But it assesses all this information on a ‘whole business’ basis. 

One of our first tasks was to do a ‘customer classification’. We split all the customers into three categories. Large and profitable accounts from important customers – group A. Small, low value and difficult customers – group C – and the core business of typical sized OK customers in the middle – group B.

What this showed (as is the case in the majority of businesses), is the A customers were small in number (less than 5% of all accounts), but accounted for a big slice of turnover (around 66% of total sales). We identified around 32% of turnover came from B customers and they were about 45% of all accounts. This left just 2% of turnover from around 50% of customers, from the C category.

So how does this information help?

Firstly, it shows how critical A customers are to the business and poses some important questions. How often are they contacted? Who is building relationships with them? What ideas, input, advice and support are you offering to them? 

In this particular business the answer was that A customers were getting the same treatment as everyone else, and that changed as soon as the analysis was done.

What it also highlighted was that over half of the customers reflected just 2% of all sales. You don’t need to be an accountant to know that this was not a profitable part of the business. In fact, a further extension of the customer classification was to identify the profit generated by groups A, B and C.  This showed that 85% of all profit came from A, 30% came from B, meaning that C was responsible for minus 15%.  In other words, the company was losing money on this group of customers.

Why are C grade customers loss making?

Let’s consider a typical interaction. The customer rings up and asks “have you got X”. The answer is “yes, and the price is £y”. The customer then asks for a quote to be e-mailed and accepts by return e-mail. Sale done. 

Someone then picks, packs and ships. An invoice is raised and sent. A statement is raised and sent. The customer gets two months free credit. Even the simplest of transactions would cost say £5 in wages, overheads and finance costs. So, in this 25% gross profit business, any invoice below £20 makes no money. There were 14,000 transactions below £20 in the year we analysed.

The emotional response from sales people was that every sale contributed to the overall costs of the business, or they might become a bigger spender next year. There are lots of excuses. The financial analysis simply shows they cost the business money. What can you do about this?

• Increase the margins for these customers so you do make a profit
• Minimum order quantities to make transactions more cost effective
• Charge more for delivery
• No credit
• Online accounts only to reduce transaction costs

And as a last resort, ask them to leave! 

In the example above, the business would have increased profits by 15% by sacking 50% of its customers. What would that liberate in time and energy to serve or win better accounts?

These are just two simple illustrations of how good financial analysis affects the way a business should operate, and why ‘emotional’ decisions are so often wrong. Many of the businesses we work with don’t have adequate financial information to make the right decisions, they don’t train their team to understand the mathematics and financial consequences of discounts or small order levels, and they look at the business as one single entity making ‘averaged’ decisions on how they serve customers rather than differentiating between the top, middle and bottom categories.

If you would like to know more about the 5 ways to grow your business profits, then read, Pricing for Profit (available on Amazon) or attend the upcoming BPMA member webinar on 7 September. Visit bpma.co.uk/events to register for this.

 

Peter Hill has been advising clients of Mark Holt & Co for more than 30 years, guiding them on all aspects of their business and personal financial affairs. Contact him on phill@markholt.co.uk or 01752 229079.