Some customers make you money and others take it from you.
We once worked with a small manufacturing business who thought they were making 3% net profit. We had the pleasure of telling them that the figure was actually closer to 9%. Less happily, one of our colleagues worked with a trading business that had the reverse problem; they thought they were making 5% but were actually losing 1%. Every sale they made was a direct loss. They may as well have sat in the office sending out envelopes of cash instead of products. The more they grew, the more they lost.
Profit margin per customer is an important measure. It determines how you price your product or service in competitive situations. For many businesses, there is a Pareto Effect: 20% of customers contribute 80% of profits. So improving margins often means recognising those customers to whom you are losing money and doing something about it.
You Need Granularity Of Information
Accuracy is fundamental when it comes to the financial management of your business. Forgetting something can make it appear that you have more or less money flowing through your business than you actually do.
While on some occasions this isn’t a major problem – there are times when this can be a significant concern. One such instance is when you are looking at your profit margins.
Why Is Profit Margin Accuracy So Important?
The core purpose of a business is to generate profit. This is how business owners earn their living and fund their lifestyles. Being aware of the difference between cost and revenue for each customer is essential for knowing whether your time is being spent effectively or not.
Do you know your hourly rate? This can either be calculated by your salary divided by the many hours you work in the business; or more tellingly, the opportunity cost of your time – what income could you be generating for your business in that hour spent chasing a customer for payment?
If the profit margins are too low, then you could be undertaking too much work, requiring too much of your time. The lower the profit margin, the longer it will take to generate profit and the lower your rate per hour will be.
If you don’t know how accurate your profit margin is – you may be undervaluing or overvaluing your time. This can have a significant impact on your long term financial performance and business success.
Major Mistake: Not All Customers Are The Same!
One of the biggest errors business leaders make when they are calculating their profit margins is that they consider each client to be the same. Most clients have different requirements and the time spent on their orders can vary; so the costs for each client change and so will the profit margin be different for each customer.
You need to look at each customer individually and calculate the amount of time and materials that have been utilised to produce their order. Then look at the time taken and see how much of your fixed costs can be assigned to each order. This will be completely dependent upon the length of time each order has taken.
The longer the work takes, the more fixed costs that should be assigned in the profit margin calculation and therefore the smaller the profit margin is likely to be.
4 Steps To Ensure You Are Not Sending Envelopes Of Cash To Your Customers
Here are 4 tips to ensure you calculate your profit margins accurately:
- Verify Your Data Is Accurate Prior To Calculation – Calculating your profit margins is one of the hardest financial management tasks. Many businesses struggle to calculate their profit margins because they don’t have the true costs of delivering their product / service. Therefore, ensure that you have as much data as possible in as much granularity as possible and that it is accurate. You need someone who understands just how to do this and to set your systems up properly – once this has been done it will pay dividends.
- Share Your Findings – To get the most from your data, you need to share the information with others in your business. Once you’ve calculated your profit margins, share the findings with all your managers and ensure this is cascaded to others. Without this visibility it is very hard to get everyone to row in the same direction. A useful test is to ask the question “will it make the boat go faster?” (Here is a link to the book of same title).
- Think about Indirect Consequences – The profit margin of a product isn’t the only measure of whether you should discontinue it or not. There are numerous other concerns that you must consider; for instance, what might your customers’ reactions be. A product with a lower profit margin might sell in larger volumes and be far easier to produce for you than a product with a larger profit margin. Removing this lower margin product could mean your general profits are significantly lowered and put your business’s financial future at risk.
- Keep On Analysing – Costs are constantly changing and so are your skills and processes. As time marches on, your costs may lessen the profit margin or your efficiency may improve so that your product is delivered more quickly. Monitoring these changes can help you determine when a product is no longer profitable.
Conclusion
Your profit margins are a critical aspect of your financial management. By knowing what your profit margins are, you can determine whether you are valuing your time or not and whether you need to discontinue a product / service to remain financially efficient.
To help, you need to ensure the accuracy of your data with continuous monitoring, as costs are always changing.
Tectona will help your business understand and realise its financial potential. Contact us today if you would like a free Quad² assessment of the potential of your business.
[Quad² is a Tectona offer – which only takes about 4 hours end to end – enabling you to fully understand just where you are making money in your business and, critically, the things you must focus on in priority to all others].