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:
- 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.