Business Owner Mistake: The Basic Profit Model is not Leveraged

As business owners, we must always leverage the basic profit model.  We are in business to make a profit. The basic profit model is simple, but powerful tool and works for any business.

The formula is:Profit

  • Leads x Conversion Rate = Customers
  • Customers x Number of Transactions x Average Profit per Sales = Revenue
  • Revenue x Margin = PROFIT. 

Medical:  Old patients + new patients = Patients x average revenue per office visit = revenue.  Revenue x (1-(revenue-cost) = profit.

Distribution: Number of invoices x average per invoice = revenue.  Revenue x margin = profit.

Manufacturing: Customers x average invoice less cost per unit less operating costs = profit.

It’s all the same basic formula:   Leads x Conversion Rate = Customers.  Customers x Number of Transactions x Average Profit per Sales = Revenue.  (Revenue- Cost) /Revenue  = Margin.  Revenue x Margin = PROFIT.

Let’s break it down:

1) Leads multiplied by how many people/companies/patients actually buy from you equal your customers.  You know your current customer base proven by your invoice register.  How can your marketing efforts improve to increase the customer base?

2) Each customer (or a patient if medical practice) purchases a certain number of times per year at an average profit per invoice.  Look at your invoice register to determine the actual historical numbers.  How can you increase purchase frequency?  How can you increase the average invoice value?

3) Sales multiplied by margin equals your profit.  How can you reduce your costs and increase your margin?

A slight increase in any of these components can have a dramatic effect on your net income.  First start with your actual numbers—do not make assumptions here.  Develop plans and goals to increase some of the variables.  See the linked spreadsheet to see the power for the basic profit model.

For small and medium-size companies, I like to focus on average transaction, number of transactions per year amount, and gross profit.  The model on the linked spreadsheet is based on actual results with a small truck parts distributor.  We increase .25 leads per day, increase average transaction size from $189 to $225 and increase gross margin 1/10th of a percent.  The impact to this company is a 32% increase in profitability.

For example, strategies to increase average transaction size include:

  • Change product/service mix.
  • Offer add-on products and cross selling of similar products.
  • Reduce number of low dollar customers: increase minimum orders, train sales staff.
  • Look at your freight policy. Increase your free freight threshold.
  • Bundle/kit products together based on customer needs.
  • Raise pricing. This is never popular with the sales guys, but this can make a huge difference.

As you grow and develop, however, things can change.  You may need to address capacity challenges – How is it possible to get more patients through the basic business formula with the current staff and processes, etc.  Fundamentally, the formula still applies, but you may need to address necessary growth challenges.

Run your own numbers and consider how an increase each of the levers can have a quantum effect on profit.  Even slight improvements over many transactions can have a huge impact.

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Growth for the Right Reasons

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You’ve seen it – I’ve written it. I’ve believed it. Grow or Die. That’s been the mantra my whole business life. If you’re not growing, you’re dying. There’s a lot of truth to the idea, but I don’t think the grow-or-die mentality is correct anymore.

Growing your business is a double-edged sword. Bigger is not better, it’s just bigger. Sometimes growth is good and sometimes it’s bad. Growth takes more time, more capital, more people, better people, better IT, better controls and processes, etc.

Being bigger means different competitors and can certainly take you away from your core and true business. Business growth can mean more business risk; I’ve seen many growth companies shooting from the hip with no growth planning go out of business. They can’t handle the growth—they can’t focus on strategy and run out of cash.

Planned growth for the right reasons is the answer. Planned growth focuses on your strategy and requires continual improvements. Planned growth focuses to reduce business risk and improve your overall business value. The plan and strategy let you focus on profitable growth.

Sometimes you need to let things catch-up. Using the car analogy, you can’t always go full speed. The engine will eventually seize. Think of your leadership and growth like a gas pedal. Sometimes you punch it and accelerate, but many sometimes you need to slow down and assess the obstacles, and sometimes you cruise at 75. You don’t bury the speedometer and run full speed all the time.  The engine can’t take it. Successful companies attack gross the same way.

Business growth is like farming – sometimes you plow, sometimes you plant, sometimes you water, sometimes you wait, sometimes you weed, and sometimes you harvest.

My “aha” moment came when I was reviewing a business plan for a rapidly growing company I’m just starting to work with. They were projecting growth as linear. One thing we all know is growth is rarely linear. Look at any growth company’s revenue – it looks like my EKG – up, down, flat, up, down, etc.

Growth is much easier to manage with linear growth – cash flow is more predictable which support cash uses. Nonlinear growth poses obvious cash flow issues when expenses are greater than gross margin or tied up in accounts receivable.

What’s the best way to approach growth?

  • Growth is rarely linear – plan to the bumps with proper cash flow planning.
  • Growth takes capital – plan for your capital needs well in advance of the need.
  • Growth takes talent – You’ll likely need different people – the people that got you here, may not be the best people to take to into the future – they may not have the skill set to handle growth needs. Focus on developing people, but know you may need to make some changes.
  • Growth takes better systems and process – Know your system and process weaknesses and work to improve or replace.

Need help evaluating your companies growth pattern? Contact me.

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