If your business is not making enough profit, then you don't have a business... you have a charity!

That’s a quote, and I’m going to quote a bit more. It’s from Dr. Greg Chapman of Empower Business Solutions.  I interviewed Greg a year ago on a different topic, but you might find something he said elsewhere useful.   I know I did, because it supports a fundamental at the heart of being a “Profits Leak Detective”.

“Whenever you read an article about business growth, it almost always comes down to a push to increase sales, but there are times when this may have totally the opposite effect that was intended.

The big mistake businesses make is using Sales as a proxy for growth. When economists speak about growth, they look at profit, which is not the same Sales. In certain circumstances, increases in Sales can reduce profitability, but people continue to use Sales as an indicator of growth because it’s easy to measure.

So when does using Sales as a proxy for growth break down? Firstly, it needs to be recognised that all sales are not equal. Some will be more profitable than others. More resources are used in making some sales, and in service delivery than others. This requires deeper analysis than most business owners typically undertake.

If businesses don’t fully allocate their cost of sales and cost of services, it’s likely that there is a cross subsidy between their products and services with the less profitable ones being subsidised by the more profitable ones and increased sales of the former actually decreasing the profitability of the business.

It’s likely that such businesses are under pricing some of their products and services, and are not as competitive as they could be in others. Pricing is an essential part of a business’ marketing strategy and poor pricing can damage a business’ chances of success.”

There are two key elements here.  My mantra has always been that it is not the volume of sales that is the key to profitability, but rather is the volume of Gross Profits.   And Gross Profit is the difference between the Price and Cost of Sales.

Let’s discuss some of Dr. Chapman’s points:

“All sales are not equal”.  Very true; as you know, 80% of your sales will come from 20% of your customers.  It costs money to acquire a customer.  Returning customers buy more and are easier to sell to, and to service.

“It’s likely there is a cross subsidy between their products and service”.  The 80-20 rule also applies to the profitability of your sales.  However, I would go beyond Dr. Chapman’s suggestion that this is down to businesses not fully allocating their cost of sales and cost of services.  He is certainly right – they don’t, but sometimes they incorrectly allocate them, and sometimes they don’t allocate them at all, merely applying a broad margin that is supposed to cover everything.  A frequent error I have found is some variable costs, i.e. Costs of Sales buried in their Fixed Costs, in which case they certainly won’t be correctly allocated.

When we fully allocated Cost of Sales for one client, we found that that a whole division of the company had a negative Gross Profit; their Cost of Sales was greater than the sales of that division.  Definitively a case of cross-subsidisation, with the very-profitable other division being dragged down.

“It’s likely that such businesses are under-pricing their products and services, and are not as competitive as they could be in others.”  Very true.  Businesses that don’t know their costs are most likely to apply blanket mark-up margins across the board and not have a pricing strategy at all.

Pricing will be based on costs alone, and not on value.  Don’t get me wrong, you must know your costs.  Trying to price without knowing your costs is like playing that childhood game of “pin the tail on the donkey” while blind-folded. 

As I wrote elsewhere “The road to success is paved with good information.” 

But you also must know your market, and your ideal customer and the nature of the problem your potential customer is experiencing, the problem your product or service will solve. 

If you are under-pricing, then you are leaving money on the table.  If you are over-pricing, you will be losing sales, because you offering doesn’t represent value in the eyes of your prospective customers.

“Pricing is an essential part of a business’ marketing strategy”.  I couldn’t agree more.  Most small businesses don’t have one, yet it is fundamental to how you are perceived in the market place.  For example, where do you want to be positioned in the market place, el cheapo, value for money, quality?  Price has its role to play in all of these.

Pricing is something I have written about quite extensively:  Business is what, if you don’t have   Are you making these pricing mistakes?, The Paradox of Pricing, Do you set your prices to maximise Sales?

So when shouldn’t you increase sales?  You shouldn’t when those sales are costing you money, leaking profits.  And the key is – do you really know?

What is your pricing strategy?

Do you face that dilemma, trying to reconcile the need to improve profitability with the threat of losing customers if you do raise your prices?  If you would like to discuss how you could generate a continuous stream of profitable customers, keep those customers and minimise customer churn through an improved pricing strategy, contact me.  There’s no cost for a consultation.  It is my gift to you.

© Copyright 2016 Adam Gordon, The Profits Leak Detective 

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