By John Fordham, above, management consultant and business adviser
Failure can just creep up on companies without management realising. The reason is because they do not properly monitor and pay attention to one major key performance indicator which looks at the trend of the business. That is Gross Profit Management. Other indicators are also important, and with all the usual existing data, sufficient action can usually be taken to improve company profitability and sustainability. The need is to get the data in the right format so it is understandable.
- Manage and act on the Gross Profit indicators.
First the big one. Poor understanding and management of gross profit, followed by necessary actions to achieve profitability is usually the major cause of company failures. Gross profit is the figure arrived at as follows; Sales income – less materials, production consumables, packing and transport – less direct labour costs = gross profit value. The percent figure should always be shown as well for the trend and analysis purposes. The GP figure should be what I call ‘clean gross profit’. This means not including depreciation, nor quality control, nor odd overheads that I have found some accountants have included, which then distorts the trend. The gross profit percent would typically be between 30% and 40% for many companies. The gross profit is the figure which shows the money you have made from the business. The money is then used to pay for all the overheads and make a profit. In summary down to the gross profit figure is where you make the money; below the gross profit figure in the accounts is where you spend the money.
The percentage trend for product materials and direct labour must be monitored. If the materials percent (against sales) is increasing, does that mean sales prices are declining? Or maybe materials/product purchasing costs have increased? Here you need to take action. Has the percentage for direct labour increased? This percent should ideally be maintained and even decreased with better automation and systems.
The GP and direct costs percentages trends should be considered for the previous two years and the current year. You can then see where you were, where you are, and where you are going. I have turned around a few unprofitable companies, which had a GP of around 20% and less. One company had not raised a customer’s prices for 9 years. One big example is Thomas Cook Retail, folded in 2019. From their annual accounts, their GP figures were 2014-31%, 2015-19%, 2016-16%, 2017-15%, 2018-11%. The GP value in 2018 was £24.666m. The overhead costs were £102.680m, so a loss of £78.0 million in funds to cover overheads in just that one year alone. The overhead costs were little changed in five years, prices had dropped and direct costs increased. The writing was on the wall years earlier for Thomas Cook. The situations are similar for many SMEs.
2. Critically review product percentage margins
Having looked at the overview of GP percent, it is then necessary to review all margins. Just print out the sales and direct costs data for all products. Then rank them from worst percent margin at the top to the best at the bottom. Which are the loss makers to take action on. Basically anything below 20% for example. In simple terms, raise prices on the loss makers or stop selling them, or sell/offer an alternative.
3. Identify customers’ sales totals with percentage margins for each product or service.
After finding the loss makers, rank the sales by customers and find their loss makers. This information can normally be achieved by using the above product information and then ranking accordingly. For impact rank from worst to best so that immediate action can be identified. Then raise prices or cut. Both of these need to be done with care and planning.
- Raise prices.
We have found that some companies have not raised prices for years and do not know how to. Obviously, if possible, new prices should be competitive with similar competitors or products. You need to fully understand your costs, minimum percentage margin required and progress from there. Benchmark your product and prices against competition to discuss with customers. One company I took over to manage had been losing money for 10 years because prices were too low. We increased prices, improved customer service, and production efficiency, and went quickly into profit.
- Improve cash situation
Debtors. Many SME’s are reluctant to chase customers for the money. This means some debtors are outstanding for 60, 90 or even 120 days. You are entitled to ask for the money, certainly within 45 to 60 days. If sales are £1million in a year, the sales are approximately £3000 per day. So 60 days of debt would be £180,000. If debtors slip to 90 days that is an extra £90,000 tied up.
Creditors. I have seen companies paying creditors in 30 days and collecting the debtors in 60 days. Ideally pay creditors in 45 days and collect the debts in 45 days, then you are tying up less cash.
Stocks. Stocks should be no more than 6 to 8 weeks of sales depending on the supply chain. Ideally stocks should not be more than one month, so stock turn is 12 times per year. The car industry and food retailers have their stock down to days and less. If you have £1million sales company, with material costs of say 25%, with 6 months stocks that is £125,000 tied up. If you get that down to 2 months, that is £42,000 in stocks which saves £83,000.
So cash saving for a £1million company, and pro rata, with better debt collection and stock holding reduction could increase cash by £100,000.
- Cut overheads.
If the company is floundering and there is reducing gross profit to cover overheads, then overheads must be cut. Of course it’s not easy but actions can be laying off staff, closing premises or space, or sub-letting and renting to save money.
John Fordham is a management consultant and business adviser with decades of experience in helping turn businesses around to become profitable. He is the author of Rocketship Management: How to Propel your Business to New Heights. www.rocketshipmgmt.com.