You begin your profit analysis by determining the exact gross sales revenues that you receive from a product or service, after all subtractions for defects, returns, breakage, loss, wastage and bad debts. Take every single deduction so that your gross dollar amount is completely accurate, and you are crystal clear about the exact amount you are netting from sales.
Once you have an accurate top line figure, the next step is for you to determine 100% of the costs of providing that product or service to the customer. These include the direct costs of producing and delivering the product or service, plus the indirect, variable, semi-variable and fixed costs that must be allocated to get an accurate number. You must be absolutely, brutally honest with yourself in determining these costs.
Apportion Costs Accurately
You must calculate and deduct a percentage of the labor costs of every person in the organization who has anything to do with the product or service. You should deduct a portion of the rent, the electricity, the telephones, the utilities and all general administration costs. These are real costs of doing business that must be included for you to get an accurate assessment of that product’s profitability.
Now, if you haven’t done it already, you deduct a percentage of all costs of advertising, promotion, marketing, labor, commissions, and especially, your own time investment, and the time investment of other executives, based on yours and their hourly rates from each unit of product or service sold.
Calculate the Hourly Rates
People are often confused about the subject of hourly rate. The fact is that it costs a company three to six times a person’s salary to keep him or her employed. The additional costs are included in benefits provided, the costs of the offices and other facilities a person needs to do his or her job, vacations, pension plan contributions, and the cost of other managers and staff to supervise or support him. Using a simple calculation, you can divide your annual income by 2000 hours, the average American work year, to get your hourly rate. For example, if you earn $100,000 per year, divided by 2000, your hourly rate is equal to $50 per hour. Therefore, every hour you spend on a product or project is costing your company that amount in direct salary cost, plus at least twice that amount in associated or “indirect costs.” This is real figure that must be included to calculate the true profits that the company earns from a product or a customer.
Include the Opportunity Costs
Many small businesses owners and managers forget that their labor has a real “opportunity” cost. If it was applied to another task, it could be generating $50, $100 and more per hour. If you spend one hour working on a sale, you must add one hour of your time to the cost of making that sale, or deduct the cost of one hour from the profit the company made from that sale.
Many companies find that, because of the demands that some customers place on their executives and staff, the company is actually losing money every time it does business with that particular customer. We call this a “high maintenance” customer. The more time you spend with “high maintenance” customers, the less time you have to spend with other customers who may be more profitable in terms of net dollars to your business.
Rank All Your Products
Now you are ready for the next step, ranking all your products or services, from the most profitable to the least profitable, on a list. What is your number one, most profitable product, after you have deducted all your possible costs, both direct and indirect?
Often there is little or no relationship between the amount of time and money you spend creating and selling a product and the amount of profit you earn on that product after all costs are deducted. Sometimes your most profitable products, activities or customers are taken for granted, or go unnoticed.
Identify your most profitable customers, and your least profitable. What are the common characteristics of each type? How could you structure your business so that you attract and keep more of those customers that represent the most profit to you for what you sell?
Face the Bitter Truth
You will probably find that fully half of your product and service offerings are generating very little profit, or even causing you to lose money with every sale. A turnaround specialist would immediately either raise the prices of the low profit items or discontinue them altogether. You must do the same.
You can often transform your results and increase your profitability quickly by applying a rigid profit analysis to everything you sell. You could probably discontinue fully 80% of your product or service lines without any great loss. You could then commit 100% of your people and resources to the 20% of products or services that account for 80% of your profits today. Think about what a difference that would make!
Take a long time perspective on your business. Think about your best and most profitable products of today. Then, think about your best and most profitable products of yesterday. Based on the trends in your business, what are likely to be your most profitable products and services of tomorrow? Remember, “The best way to predict the future is to create it.”
Look Into Yourself
Finally, look at yourself as a business, as well. Identify the few things you do that make the greatest contribution to your organization. What activities pay you the highest hourly rate? What are the opportunities of tomorrow for you? What additional skills and competencies could you acquire that would make you even more valuable in the months and years ahead? Whatever they are, the time to start learning them is now. There is no time to waste.
Pump Up Your Profits:
1. Do a complete profit analysis on every product and service you offer. Rank them from highest to lowest.
2. Identify the 20% of your products that account for 80% of your sales. Which are they?
3. Identify the 20% of your products and services that account for 80% of your profits. Are they the same as your answer to #2?
4. After deducting all direct and indirect costs, which are your most profitable products or services based on cost and return on investment?
5. How much is your time worth on an hourly basis? Build this cost into everything you do to get an accurate measure of costs and profitability.
6. Attribute a percentage of all general and administrative costs to each product or service you sell. This exercise often turns profits into losses.
7. If your company was facing serious financial shortages, which products or services would you focus your energies on, and which would you discontinue? Think about doing it now.
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