20 Oct Why Increasing Sales Isn’t Always a Good Idea
We are passionate about entrepreneurs who have the ability to start, grow, and execute. We are particularly interested in managers who are familiar with swimming in the ambiguous waters of entrepreneurship.
When looking to scale a business, it is absolutely imperative that you declare a gross profit goal and watch it like a hawk. Align your accounting methodologies with your industry’s best practices to make your goals comparable with competitors. Consult RMA comparative data to learn what type of gross margins the profit leaders in your industry achieve and set appropriate gross margin goals. Gross Margin is total sales revenues – cost of goods sold, divided by total sales revenue, expressed as a percentage. You should review your gross margin each month (preferably each week) for the entire firm, by department, by each product/service line, and each product or job to monitor which areas of your business are assisting or preventing your business from reaching your goals.
For example, let’s take Firm XYZ with projected annual sales of $3,000,000 and annual material costs of $2,000,000 with $500,000 in labor and $320,000 in overhead costs. At the end of the year, Firm XYZ profits $180,000 with a 6% Profit Margin. Let’s say the owner has the option of pursuing a supplier to decrease the cost of materials by 5% or implement a new marketing campaign that is projected to increase sales by 20%. Which would be the better option?
If the owner decided to increase sales by 20%, annual sales revenue would increase to $3,600,000. However, with this increase in production, COGS would also increase by 20% to $3,384,000. With this method, Firm XYZ profits $218,000 and has a Profit Margin of 6.06%.
If the owner decides to decrease the cost of materials by 5%, the annual sales revenue remains the same at $3,000,000 as well as the annual labor costs of $500,000 and overhead costs of $320,000. The 5% decrease in the cost of materials lowers the COGS to $2,720,000 and Firm XYZ profits $280,000 with an effective Profit Margin of 9.3%.
At first glance, it may appear that the best way to increase profits is to increase sales revenues. However, a small change in the cost of purchased products and services can have a more significant impact on profits than a large change in sales. Clearly the owner should pursue the supplier offering cheaper materials.
Although decreasing material costs is an extremely effective way of improving your company’s bottom line, it is important to keep product quality in mind as you source materials and services as they can also affect profitability.
We aim to take companies that entrepreneurs have started and provide the capital to take the risk off the table for the owner(s) and help grow the company to its next level of profitability.