Five profit margin killers you must eliminate

How to stop profit leakage from draining your company’s lifeblood

Your business is enjoying growing sales, but you’re frustrated every month when you see your profits are stagnant or even shrinking. If this sounds familiar, you’re probably a victim of profit margin killers that are draining your business’s lifeblood.

Margin killers are oversights and inefficiencies throughout your business that may seem small on their own but together can make the difference between a flourishing company and one that struggles to survive.

The ability to eliminate margin killers is what separates the best companies from the laggards in every industry.

So how do you fight margin killers? The first step is to get a clear understanding of how profit is measured using your financial statements.

Two ways of measuring profit

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As you can see in the income statement example above, there are two measures of profit.

The first is the gross profit. It reflects the amount of money a company has left over after accounting for its direct costs to make a product or deliver a service. Direct costs include labour, materials and other expenses that are directly related to producing a product or service. In this example gross margins (which are gross profits as a percentage of sales) are 66 per cent of sales.

The second, net income, is a more comprehensive measure. It takes into account not only your direct costs but also all your other expenses, including overhead to operate the business, taxes and interest paid on debt. After reflecting overhead costs, the net income margin is only 12 per cent of sales.

You can see there are layers of expenses where margin killers may be lurking. But it’s not only unnecessary expenses that can hurt your bottom line. You may also be failing to collect all the money you should from your customers.

The key to reducing and eliminating profit killers is to be able to dissect your financial statements and highlight the areas where you are losing money and see what strategies you can use to prevent cost and revenue leakage.

With this in mind, let’s look at five margin killers and how to eliminate them.

1Pricing that doesn’t reflect your true costs

It’s common for companies to neglect or low-ball expenses when setting prices. For example, an HVAC company will charge for technician time spent on a project but fail to include travel time to the site.

You have to closely examine your direct and overhead costs to make sure they are all reflected in how you calculate your profit margins and pricing. This is even more important during a time of rising inflation. Your suppliers are raising the prices they charge you. You need to ensure your prices reflect this reality.

Are you worried about customers going to a competitor if you raise your prices? You don’t have any choice. You’re in business to make money and that sometimes involves tough choices and difficult conversations. The best solution is to be transparent with customers and explain what you have to pay to provide them with a product or service. If your company isn’t competitive at a fair price, you need to make necessary changes to your business and/or operating model.

2Holding onto unprofitable products

Some products are costing you money and you may not even be aware of it. It’s important to analyze your financial data to break out the profitability of individual products and services. You will likely find you are carrying winners and losers.

Once you have identified unprofitable items you can decide what to do about it.

Could you raise your price for those items?

Should you keep the product because it is a strategic requirement to win other sales?

Is there a better way to produce or offer them?

Or do you have to eliminate them altogether?

3Failing to manage customer relationships

It’s a fact of life some customers require more time and attention than others. That means they are more expensive for your business. For example, they may ask for changes or add-ons that weren’t included in the contract you signed.

Too often, companies go along with doing extra work without charging for it.

The key to dealing these kind of margin killers is to plan ahead and be vigilant. Stipulate in your contracts how changes and add-ons will be invoiced. Make sure your team always tells you about unanticipated requests before the work is done and then inform the customer what it will cost.

4Allowing direct and overhead costs to grow uncontrolled

Growing revenues can often lead to a lack of rigour on expense control. A close look at where dollars are going may reveal rising costs for such things as new employees, vehicles or advertising and marketing that are not producing a corresponding increase in revenue.

Be vigilant on your gross margins, if they are creeping down your productivity may be declining and you need to get to this issue immediately.

Furthermore, to control overheads, set budgets for your overhead expenses and stick to them. The amount budgeted for each line item should be based on analysis rather than simply using last year’s numbers. A business case should be made for any substantial increase.

To cut expenses, use the 80/20 rule when deciding which ones to attack first. Look at the outlays that represent 80 per cent of your total expenses and work on reducing those. That’s where you will get the best results.

It’s also a good practice to go to the market periodically to see if you can get a better deal on fixed costs, such as insurance, telecommunications services and maintenance contracts.

5Failing to use technology

Technology-based solutions are invaluable in the fight to eliminate profit killers. They will help you find where profit is leaking and optimize your operations, customer relations and pricing.

You can use your accounting software to calculate your profit margins, track your expenses and monitor asset turnover, among other key performance indicators.

Manufacturers can use software to monitor how much downtime they are experiencing for factory line changeovers and equipment repairs. Similarly, timesheet tracking software allows you to monitor worker productivity and generate data for invoicing.

Once you’ve identified margin killers, you can work to continuously improve by using a dashboard and KPIs to monitor progress towards your goals.

Download BDC’s eBook Monitoring Your Business Performance to learn more about key financial ratios.

By Alka Sood, BDC senior business advisor