Prioritise profit!
Not all business owners love numbers. In fact, most don’t.
They know that understanding the data is important, but often outsource this responsibility to the finance department or their accountants, working on the basis that if sales are good and there’s ‘enough’ cash in the bank, then everything is ok.
I appreciate this might be a generalisation, but it’s a common reality with potentially damaging consequences, if unaddressed.
Numerical understanding is an imperative for leaders who want to run profitable companies, not a luxury.
A limiting mindset – Turnover obsession
When starting and then scaling a business it’s natural to become fixated on the turnover generated, as opposed to the profit made.
There are a few underlying reasons why this can be the case. First, it’s easy to measure; second, just generating ‘enough’ can make things seem satisfactory; third, it’s the default metric businesspeople use to describe their company, i.e. ‘we turnover XXX.’
It can be tempting to build your organisation around this vanity metric, because traditionally we set up sales commissions around it and even judge our own fulfilment and value against it.
Turnover should not be your primary focus for these three very important reasons:
1. It’s a lag metric (an outcome), which are harder to impact or improve
2. It shows the size of the business, but not its efficiency
3. It can give us a false sense of success, which can be disastrous in extreme cases
Businesses fail not because they run out of turnover, but because they run out of cash. The two are not the same.
A missing element – Profit margins
There are three essential margins that all businesses can be compared to (and against), which are more relevant than pure turnover.
The first is gross profit. This is the profit after the cost of sales has been deducted from the turnover, taking into account the costs incurred in making the sales that contribute to the turnover.
The second is operating profit, which is the money left after all the standard business expenses and overheads have been paid. The percentage of operating profit (operating profit divided by turnover) is a measurement of the efficiency of the business and demonstrates to the shareholders how effectively the business is being run.
The final margin we need to understand is net profit; this is the remaining money after all accounting adjustments have been made and tax deducted. This is what’s left and is the truest measurement of how well the business is being run. Net profit margin (net profit divided by turnover) demonstrates what’s left and should be a key performance indicator for shareholders.
By regularly tracking these three profit margins, leaders will have a far better understanding of how their business is actually performing.
A different perspective – Commissions and bonuses
If you want to improve the profit margins of your business your initial step should be to educate your team on the three types of profits outlined above, so they know what’s involved in each.
The next step is to align some form of reward to the profits generated. Ideally, this would be with regard to operating profit. Gross profit doesn’t take account of the overheads, so it’s dangerous to pay out against, and net profit takes account of factors that employees can’t impact, so would seems unfair.
If everybody understands what operating profit is, how they can positively impact it, and are rewarded in some form for its improvement, then your company will be unified to one goal. Recruiting everyone to this task may not be quick, but once done, you will have a more motivated, more focused workforce.