… or, The Mathematics of Profit.

Maths might be one of your pet hates, but I promise to keep it simple.   (Secret – I'm not that fussed on it as a subject either).

Too many businesses confuse turnover/sales and profit.   The basic formula is:   Sales less cost of goods sold = Gross Profit.   Simple!   Turnover is a fact, nice to know, but doesn't really tell us much about how well the business is doing.   Gross Profit (GP) tells us a lot more.

Gross Profit is Sales less all the variable costs (those which vary with volume of sales) of selling those goods, including buying the goods, freight in and manufacturing labour.   The simple equation is:

     Gross Profit = Number of Sales x (Sale Price – Unit Cost)

That's the Maths!   Now we switch to marketing.

This formula indicates there are 4 ways to increase profit :

1. Increase the number of customers, or the number of times they buy, or the number of goods they buy (or a combination)

2. Increase the Price

3. Reduce the Cost of Goods Sold (buying price or manufactured cost)

4. A combination of the above.

Whatever combination of the above strategies, the primary focus is usually either about volume (selling more) or margin (improved prices).

A volume strategy is about marketing, getting more people through the door.   Simple economics tells us that selling in volume is mostly achieved with lower prices.   This doesn't work well for small business because SME's rarely have a cost advantage, or achieve economy of scale, or a unique process.

A margin strategy is focused around its competitive advantage or unique selling proposition or point of difference (essentially all the same thing) in a smaller or specialised niche.   This suits small business; sell less but at higher margins, so profit is higher.

Let's look at an example:

A business sells 100 items at $10 (so Sales - $1,000), with a cost per unit of $6, so GP is $400 or 40%.   Then:

a) It could reduce the price to $8, so unit sales increase to 150 and Sales are $1,200, costs are $900, and GP is $300 or 25%;

b) Or, increase prices to $12 with more effective marketing but unit sales decrease to 90, and Sales are $1,080, costs are $540, and GP is $540 or 50%.   In this example, sales volume could even fall by about 20% and the same profit would be made as before.

Apple uses b).   It has about 15% of the market but earns 80% of the profit (I read last year its cost of manufacture is around $46 per unit).   Customers buy into Apple's values and culture of innovation and are happy to pay its price and be part of that perception.

The maths means you do the sum for each strategy and choose the one that maximises the profit.   The next step requires comprehensive marketing planning as to how the required result can be achieved in practice.

Any business can get its strategy right with these steps.

1. Choose the profit strategy that would seem to best suit your way of running the business.

2. Develop the marketing strategy to achieve that level of sales volume.

3. Finish off the Business Plan to make sure nothing critical is overlooked.   (This is the Top Down Approach, or as Stephen Covey said 'Begin with the end in mind').

See, the maths isn't hard!   If you want to maximise your profit, will you seek more customers, or put prices up, or reduce your costs (or do all of these strategies?).   The order for doing thee could be:

1. Increase Prices (3% now, and 3% in 6 months)

2. Acquire more customers (marketing takes a few months to get the balance and message right).

3. Reduce Costs (ask for discounts from suppliers and even change suppliers if need be, reduce waste, etc.).