Before getting started, as a ‘prerequisite’ to this article, you should check out our article on the 5 revenue drivers if you have not already done so. Here’s the link.
I have yet to meet a business owner who did not want to improve their profits, either through increasing the amount of it, or the percentage of it.
How do you do that if you don’t know what levers to pull? How do you do that if you’re not keeping track, or ‘keeping score’ as we say, of these numbers?
You’re just guessing…throwing darts with your eyes closed hoping to hit a bullseye.
This article is going to teach you how to open your eyes and throw at the target so you get the ‘score’ you want.
By the end of this article you will have a simple and crystal clear way to understand and manage the profitability of your business.
Below we will discuss:
1. The 5 ‘drivers’ you have to increase profit.
2. A simple way to understand and analyze these drivers.
3. Why you should focus on monitoring the trends to improve profitability.
The 5 Profit Drivers.
There are 5 key numbers to track and monitor profit. They are:
Driver 1 – Revenue
This comes from sales and the goal is obviously to keep as much of it as possible.
While there’s 5 drivers for revenue, the profit driver is just revenue.
Driver 2 – Cost of Goods Sold / Cost of Sales, as a % of revenue
This is the direct costs to produce/provide your product or service.
If you’re a marketing agency, this is the cost of your delivery team. If you own a home services business, it’s your field technicians and probably your cost to put gasoline in all those trucks, as well as any materials you supply to your customer
The lower the cost of goods sold % is, the more profit you have.
Note: This is not to be confused with sales expense or as some might call it, cost of sales.
Driver 3 – Payroll Expenses, as a % of revenue
This is the cost of your payroll which is not included in your cost of goods sold. For instance, any payroll such as administration, back office, etc.
Driver 4 – Marketing Expenses, as a % of revenue
This is the cost of all of your marketing efforts – SEO, digital advertising, print advertising, money you spend on ‘marketing/branding’ efforts, etc.
We want to capture everything which should be driving new leads to measure it’s ROI.
As a side note, you may or may not choose to include sales expenses in this bucket. What’s important is consistency.
Driver 5 – Overhead Expenses, as a % of revenue
To make this simple, this is the catch-all for every expense that is not covered above. The typical income statement has way too much information, too many lines so we want to simplify things. How much you spend on software and office supplies isn’t important right now. (It could be, but it’s not until you know there’s an issue.) You just need an understanding of the overhead ‘bucket’.
That’s all 5 profit drivers. These are your ‘levers’ to pull to improve profitability. Below is what it looks like in a formula. You’ll see that it’s effectively a very simple income statement.
A simple way to understand and analyze these drivers.
The standard income statement most small business owners are viewing can be confusing.
There’s typically way too many lines (which is why we group into only 5 profit drivers) and it’s a giant page of numbers, from last month/quarter/year.
It’s really hard to look at and understand whether your numbers are good or bad other than just looking at your bottom line profit number. However, that can be dangerous…you could be ‘leaking profit’ but these drivers will help you spot that. Reports that don’t answer the question, “is this good or bad” are useless.
One way to fix this is by using these profit drivers and viewing them as a percentage of revenue.
What does that mean?
It means you divide the actual expense number by your revenue. For example, if your cost of goods sold is $60,000 and your revenue is $100,000, then your cost of goods sold percentage is 60% (of revenue).
Why is this better than using the absolute dollar value for the expenses?
Simply put, it shows you the ratio between how much you spend in cost of sales, payroll, marketing or overhead to produce the revenue results.
For example, if you look at marketing expenses and see they increased from $5,000 to $6,500, you have no idea if that’s good or bad. It went up, so the first reaction might be, it’s bad.
Now, if your revenue increased from $100,000 to $150,000 in that same period, and you look at marketing expenses as a % of revenue, you’d see it went from 5% down to 4.3%. That’s a win! Yes, you spent $1,500 more, but it generated a higher return on investment…or in English, your dollars worked harder for you.
That’s why we look at these drivers as a percentage of revenue.
Managing profitability is essentially a game of percentages and these profit drivers are those key percentages.
Here’s another benefit to using the profit drivers as a percent of revenue – as you grow, your expenses will likely increase. Understanding the profit drivers will help you keep a pulse on what’s good or bad, working or not working, in the different areas of your business.
That brings me to the final point…
Monitoring the profit driver trends to manage and improve profit.
We recommend monitoring your profit drivers monthly and comparing them to prior time periods such as last year.
If you see your trends for each profit driver, you’ll have a better understanding of why your profits are the way they are and be aware of what’s getting better or worse.
Most importantly, you’ll be able to start planning small improvements in each of the areas behind the profit drivers. This will enable you to watch your monthly trends, hopefully seeing the percentages decrease, which means your profits are increasing.
Here’s a visual of what this could look like and for illustrative purposes it shows a reduction in the cost of sales, payroll, marketing and overhead profit drivers. The top section shows just plain old numbers. The bottom section shows the numbers as a percent of revenue – you can see how having this information let’s you better understand what’s going on in your business and how things are trending by driver.
Half of the battle of improving profitability is knowing where to start. Once you know where to start, you adjust, measure, adjust, measure, etc.
Hopefully this article helps you better understand how to start taking action today to understand and improve your profitability.
Here’s the takeaways from this article:
1. First, your standard income statement is confusing – you have permission to stop beating yourself up if it frustrates you.
2. There are 5 key profit drivers you need to understand for your business – revenue, cost of sales as a % of revenue, payroll as a % of revenue, marketing as a % of revenue and overhead as a % of revenue.
3a. Managing profit is a game of percentages – while it’s important to know how much you spend in the 4 profit drivers that are expenses, knowing the percentage of revenue spent is more useful. If you want to increase profit margin by 5%, you have to remove 5% from one or more of those 4 buckets.
3b. You can remove that 5% by a combination of increasing revenue and decreasing costs.
4. Monitor the trends of these profit drivers and set a goal to make small improvements in each one. This will improve your bottom line profit – in other words, it will free up cash to pay yourself or reinvest in the business.
Having a solid understanding of your revenue and profit drivers is all part of running your business like the CEO your company needs you to be!
QUESTIONS??? Post them in the comment section below!