Thankfully I have a full order book at the moment, but my profit margin is low by comparison to similar companies; I daren't put my prices up so what can I do?
When you use the term profit margin I will assume that you are using gross profit to compare with your competitors.
There is a golden rule in business that not all customers are equal. That's not to say that you should bow or curtsy to some and kick others. The equality I am talking about is related to the contribution each makes your gross profit.
As a business adviser I rarely find that businesses analyse customers by profitability. I often hear stories of customer Y being X% percent of the sales mix, but it is far less common for business managers to know the gross profit contribution from individual customers. There is often an assumption that contribution is in proportion to sales, or no assumption at all because no one thinks about the business that way.
You may have heard of the Pareto Principal (named after the economist Vilfredo Pareto) otherwise known as the 80-20 rule. As the theory goes, when applied to customer portfolios, 80% of your customers will contribute 20% of your profits. Which means, conversely, that 20% of your customers will contribute 80%
This may well be more or less true of your business, so do you know who the relative few are that contribute the majority of your profit, and vice versa?
However, in some companies there can be a significant proportion of customers that contribute a loss, which means that a small proportion of customers could actually generate more than 100% of gross profit.
So what should I do?
Analyse your customers starting with the largest. Unless you're a management accountant you will want to keep this as simple as possible, but you will need to, at least, compare the difference between the sales value per customer and the full costs of making those sales. This is straight forward as long as you keep decent records. There may also be hidden costs, for instance: very demanding customers needing more attention and time which is not being charged; a reluctant payer that needs chasing or even worse adversely affects your cash flow.
Draw up a profile of customer profitability and identify the factors that are driving profitability differences for each customer. The Business Link website identifies the following factors as contributing to higher customer profitability:
If you, as a sole trader, are wanting to collaborate with other sole traders, understanding the other party's style of doing business, vision, view of the world around them, their values and beliefs and behaviours will be important for effective collaboration.
If you are a larger business with staff and even possibly a management team, how you go about understanding each other's business culture will need a lot of careful thought. Each MD spending time at the other's business getting to know people and processes is a good place to start.
High contributing customers:-
This is about how you or your company actually works from end to end. How you sell, market your products & services, communicate internally, & externally, deal with suppliers, customer relationship management; how you actually make the products and provide the service, how you run your admin and finance functions etc. Don't assume that because your own business runs effectively and smoothly that there will be no difficulties when you collaborate with others even if they too have a smooth running business.
Legal & structural aspects
- buy high-margin products
- pay full price without negotiating discounts
- place a small number of large orders rather than many small orders
- do not cancel or amend orders
- pay on time, without being chased for payment
- do not require extensive after-sales service
This is self-evident but often forgotten in the scramble to close the sale.
Finally, draw up an action plan
Sounds simple enough, and then all I have to do is drop the unprofitable ones.
Sadly nothing is that simple in business. In some companies customer profitability is hard to quantify and you may need professional help.
The strategic decisions following the analysis should be carefully thought through before implementing. For instance you might sell to a nationally famous brand or person and in doing so you gain market credibility which makes you attractive to other customers. However, this may be one of your less profitable or loss-making customers, and scrapping a loss-leader like that could prove to be a disaster in the long term.
The decision as to what you should do about lower contributing customers is the hardest part of this, but the point is that if you don't know what your customers are contributing individually, then you should find out. Without this knowledge you can't even begin to consider improving your gross margin.
If you want to discuss this with an impartial adviser call Business Link.
That's all for this month.
Business Link - the place to go for business support