You have likely heard many business consultants’ advice on growing profits. Now you get to hear it from a part-time CFO, with the added bonus that mine actually works. Not because I am smarter than everyone else (that’s beside the point ), but because I have over 30 years of professional experience and have seen what makes the difference. So get on with it Shane, Mr. part-time CFO – what makes the difference?
It is very simple actually. You work very hard in your business and you should end up keeping at least 10% of what you sell as profit. Who wants to work as hard as you do and keep less than 10%?
To accomplish a 10% level of net profitability, you need to target at least a 40% gross profit. Gross profit is the profit you get on sales after subtracting your direct cost of acquiring whatever it is that you sell. To get a 40% gross profit, you need to markup your products/services at the rate of 2 times your cost. That pricing structure actually allows for a 50% margin, but after discounts, shrinkage, and theft (yuck), you should get to a 40% gross profit, once the dust settles.
So you have 40% left at this point. Keeping 10% should be easy, right? Not so fast. You would be more successful than most businesses if you can actually retain a 10% bottom line in this scenario, believe it or not. The reason is due to profit erosion from selling, general and administrative expenses. Here is the math:
Most businesses require anywhere from 10% to 20% of sales to be devoted to sales and marketing costs in order to efficiently and effectively maintain sales and sales growth. I have used 15% in this example. Sales and marketing expenses include commissioned sales people, advertising, marketing, brochures, branding, website, search engine optimization, etc. Can you spend less? Sure. Will you grow? I doubt it. You will probably start to lose market share to a competitor over time if you neglect this area.
General and Administrative Expenses
Then there are general and administrative expenses aka “blood sucking overhead.” If you can consistently keep these costs at 10% of sales or less, you are a true champion and need to write books on the subject. Last, deduct for income taxes, which brings you down to a 10% net profit retention.
Yes, my comments are overbroad and will not apply to every business and every set of circumstances. But in general, I stand by my theory that most successful businesses (defined as those that retain 10% or more of sales as profit) are those that can maintain a 40% gross profit margin. Lets look at a glaring example. In the smartphone industry in Q4 2010, Apple realized only a 4% marketshare but commanded 43% of the total profits in this sector. Isn’t that the success we all seek? Doing less busy work (unprofitable sales) and making more than the competition.
To maintain a 40% gross profit margin and thereby achieve the high 10% net profit retention described above, a company usually must sell at higher prices than those charged by the competitors. How do they get that done? I have a theory on that one too, as you might have guessed. Hint: how does Apple “gitter done?” I hope you can come back for that discussion in my next blog.