Applying Profit Analysis to Your Business

In my previous articles, I discussed in point the fundamental principle of the Income Statement and How to Analyze a Profit and Loss Statement to Maximize Profits, along with a step by step process on How to Plan for Profits.  To pull this Business Profit article series together, I will give some examples of how good Profit Analysis and Planning made for success and the flip side of that scenario (and the reasons why the companies were unprofitable).  This article will show How To Apply Profit Analysis and Planning to real world business situations. I will present 3 scenarios of Manufacturing Companies which had good profitability, mediocre profitability and one which failed.  All three companies are in the same industry.

The Successful Company:  Company A

In examining Company A’s Income Statement, there are many clues as to why it was a successful company:

– Market:  Established a market by determining a market need and effectively filling that need. In a five year period sales grew from $11K to $60m in relation to a market that grew from $413M to $510M.

– Expenses:  Expenses were reduced as a percentage of sales over the years, with Engineering and Sales Expenses at year 5 three percentage points below the industry average. The lower engineering costs were attributable to high caliber engineers who designed a superior product which required fewer development changes and allowed employees to concentrate on innovation in the subsequent years.

– Marketing Costs were low due to using a network of Distributors to sell the products alternatively than using a large sales force and manufacturing reps. The small sales force was used to concentrate on high volume accounts, giving the company a big return for its investment in its sales people.  This exclusively added 7 percentage points to its bottom-line profits.

– Cost of Sales was maintained at 62% of sales during the 4^th and 5^th years of operation which provided a 38% Gross Margin.  This GM is about 10% above the average Break Even Point for similar companies, giving Company A a good cushion of profitability.

The Mediocre Company:  Company B

Company B was a six year old company and located in a region of the country that offered lower labor and overhead costs.

– Sales Success: Company B had very aggressive pricing strategies and undercut its competitions to achieve large volume orders. Profit was not the motive; dominance was the underlying strategy.

– Aggressive Pricing:  In relation to its closest competitor, Company B’s sales were three times larger, material costs 15 percent lower and labor 5 percent lower.

– Overhead:  This is where Company B made its mistake.  Overhead expenses were 27%, causing Cost of Sales to increase to 76%, leaving a Gross Margin of only 24%, which was Break-Even in the best of circumstances when accounting for Engineering, Marketing and G&A.  This was a ripple effect which greatly reduced Company B’s profitability, causing the parent company to sell it.  An acquiring company immediate corrected the Overhead issue and installed a new General Manager to establish better profitability controls, which helped it recover over time. 

The Company Failure:  Company C

Company C captured 27% of its market, yet failed to stay profitable.

– Management:  Plagued by severe management problems.

– Spending:  Flamboyant and expensive habits.

– Product:  Poor Design and low manufacturing quality.

– Staff Reduction:  As a result of poor management, financial losses and product failures, Company C reduced its staff of 600 to 400 employees.  The Company afterward fixed its design issues, increased its market share from a significantly lower share of 2% to 4% and grew employment to 150 employees.  The Company was climbing back and barely keeping its head above water.

– Turnover: Company C experienced severe top-management problems, and as a result, lower-management, along with the technical and production ranks, suffered from excessive employee turnover.  In a year period, employee turnover was over 100%. Company C as a result experienced a bad repute in the Region’s labor pool causing it major difficulties in attracting quality employees. As a result of its low quality labor force, Company C’s product quality declined and customers were lost. The high employee turn-over created a situation that made it impossible to reduce product costs. Company C was constantly in the training mode and the domino effect of ruinous events forced it to cease operations.

– The Numbers:  COGS amounted to 84%, leaving only 16% for Engineering, Marketing, G&A and Profit.  This is clearly out of whack by 20%.  Material Costs totaling 53% could not be reduced due to high employee turn-over, which created a loss of purchasing continuity and poor procurement strategies.  Slow payments to Suppliers contributed to higher material costs since the suppliers increased their prices to compensate for the added costs of doing business with Company C. Company C strove to make improvements, but the improvements were made in the wrong places. Labor Costs were reduced from 8% to 4% and overhead from 10% to 5%, using the same products and predicting inflation rate of 13%. G&A at 3% was reduced dangerously low. The combination of indiscriminate cutting of costs, poor labor quality, poor product quality and very expensive material costs ultimately united to doom Company C.

What can be Learned From Profit Analysis?

By showing how to apply Profit and Loss Fundamentals, Profit Analysis, and Profit Planning to real world business situations, a business owner can now take these applied principles and integrate them into his or her company profit analysis and planning. Seeing how companies successfully and unsuccessfully applied these Profit Principles, the business owner can now easily apply these profit strategies to company operations. The Profit and Loss Statement is an excellent place to initiate your Profit Analysis and Planning since it shows how a business has spent its cash in hand in years past and how to projects its spending to be in the future. Moreover, this profit process clearly shows the proportion of revenue stream to expense and cost levels, and whether that ratio is healthy and/or unrealistic.

By understanding what an Income Statement is telling you, how to properly Analyze it for maximal Profits and how to successfully and realistically plan for Future profits, you can significantly increase and sustain better Cash Flows.  However, the process should not stop here.  As you have planned to Maximize Business Profits and implemented it successfully through your company’s Business Plan, Cash Flow Management becomes the next step in the Profitability process. Understanding how cash moves in and out of your business is exremely important in running a profitable and sustainable business.

About this Article Author

Frank Goley is a business consultant, business turnaround consultant and business plan consultant for ABC Business Consulting. Frank is considered an expert in writing, developing and implementing business plans, business turnaround plans, business funding plans, marketing plans, strategic plans and web marketing plans. Frank offers comprehensive business consulting, business coaching, business turnaround consulting, along with web seo, web development and web marketing consulting, to small and medium size companies.. Frank is the author of a business plan book, The Comprehensive Business Plan Workbook – A Step by Step Guide to Effective Business Planning, and he has over 50 published articles on business success strategies. He also writes the Business Success Strategies Blog.