While it’s undoubtedly true that one way to increase profits is to raise your prices, it’s rarely the most reliable. It can be difficult to predict the effect price increases will have on your sales volume. Lots of factors drive pricing, competition in the marketplace being at least as significant a determinant as your costs. So, pricing is not quite as simple as backing into the price required to get a reasonable return for your efforts. You need to consider what price the market will bear for the service or product you are offering.
I recommend to my clients that they first look at improving efficiencies. If you find yourself in a low margin situation, say 5%, and can identify fixed costs to reduce, every dollar of reduction is the equivalent of increasing sales by twenty dollars. The challenge with reducing fixed costs is that in many cases the potential fixed cost reductions impact the lifestyle of my clients. An example of this is company cars, insurance policies or rent the company is paying the owner for facilities. This takes us to a third area to look for engineering in improved profits; increased sales volume or reducing the cost of providing the service or product.
It is in this arena, increasing sales volume and reducing unit costs that the greatest value is created. The nice part about this is the two are synergistic.
Assuming your sales volume is currently at $3,000,000, and your overhead or fixed costs are $300,000 for every dollar of sales ten cents or 10% will be required to cover overhead. At $6,000,000 in sales, your fixed costs may rise but not in proportion to your sales. Let’s assume fixed costs do rise in relation to sales and that at $6,000,000 in sales your overhead has increased to $400,000 to cover additional administrative expenses of $100,000 associated with the incremental $3,000,000 in sales.
From your original $3,000,000 in sales 10% went to cover overhead but for the second $3,000,000 in sales only $100,000 or 3.33% was required to cover overhead freeing up 6.67% for incremental profit. Of course, reducing the direct costs has a similar effect and in manufacturing environments, there are frequently economies of scale (buying in greater quantities, discounts on freight with increased volume, increased production efficiencies from increased utilization of capacities) that kick in as production volumes rise and these create additional profits. However, in a firm that provides services, these economies of scale are much more difficult to achieve, and generally one must look to increased utilization of labor resources to reduce direct costs.
While increased utilization appears, at first, to be difficult, there is usually some low hanging fruit such as better routing of technicians to reduce windshield time or better discipline regarding start times. It’s not unusual for companies to start their days at 7 am, but its usually 8 am before anyone’s performing billable work. Reducing this lost time by 15 minutes every day increases utilization by 3.125%.
So, if all other factors remain the same, that 3.125% increase will translate to an equal increase in your net profits. If you are currently earning 10% net profits that you represent a 31.25% increase in your net profits. So, when you are engineering your profits and considering price increases, but do not believe the market will bear the price you need to achieve your desired profits, look at improving the efficiency of your organization. I assure you that your competitors have and that’s what’s setting the market price.
At Cogent Analytics, we never stop looking for ways to improve your business and neither should you. So, check out some of our other posts for helpful business information:
