What is the fastest way to increase a company’s profitability? (tweet this) Should the strategy be to increase revenue or cut expenses? Should they simply raise the price of their product? You may not be a business owner, but by understanding a few basics, you can become a better employee and begin to understand the company’s financial strategy.
Caution: This post is a bit on the technical side. However, if these concepts are new to you, I think you’ll find that while they may not excite you, they are worth your time to learn. I’ve tried to make it as concise and non-geeky as possible while still getting the point across. But I do have to admit in rereading it, it is still pretty dry. Press through!
In order to fully understand how profitability works, we have to define some terms.
1. Revenue – Otherwise known as top line revenue or gross sales. This is the amount of money a company receives on the sale of a product.
2. Cost of Good Sold (COGS) – These are the per unit inputs or direct costs that go into producing the product.
3. Gross Profit – This is equal to revenue minus COGS.
4. Gross Margin – This is Gross Profit expressed as a percentage.
5. Expenses – Also known as fixed costs, sunk costs, or overhead costs. These are expenses that are not directly associated with producing a unit. Examples would be rent, machinery, administrative staff.
6. Net profit or loss – Also known as profitability or the bottom line. This is calculated by subtracting all COGS and Expenses from Revenue.
What is the fastest way to improve profitability? To answer that question, we’ll look at 3 basic scenarios.
Let’s assume that Acme currently has $1000 in revenue, a 50% Gross Margin, and $300 in overhead leaving a profit of $200 or 20%. This is depicted in Column A below:
Question: In order to improve profitability, would it be more efficient for Acme to increase revenue or decrease expenses? It depends!
Increase Revenue by selling more units (Column B)- If Acme were to simply increase their revenue by $100, without increasing their overhead expense, their profitability would only go up by $50 because they would have to expend additional COGS to produce the additional units. Since their Gross Profit margin is 50%, only $50 of the additional $100 in sales would “drop to the bottom line.”
Lower Expenses (Column C) – If Acme were to not increase their revenue at all, but instead lower their expenses by $100, what would happen? By decreasing their expenses $100, they actually increase their net profitability by $100 as well. The full $100 drops to the bottom line.
While Acme only has to eliminate $100 in expenses in order to achieve a $100 increase in profitability, they would have to increase revenue by $200 to experience that same $100 bump in profitability.
Raise the per Unit Price (Column D) – Acme could also increase profitability dollar for dollar by increasing their price. Because no additional units are sold, the COGS remain constant and the additional $100 in revenue drops straight to the bottom line.
All of this is to illustrate that $100 in additional revenue is not always the same as $100 in savings.
Of course, in developing a company strategy, many factors have to be taken into consideration. For example, there are limits to how high a price can be raised or how many expenses can be eliminated. So I am not suggesting that these are always the right answer to improving profitability. If it were that easy, every company would be a huge success!