It is unfortunate, but true that financial reports prepared for tax purposes do not provide information that is needed to properly manage a business.
This business had seen it’s profit fall by $96,000 over a 3 year period. This is what it’s annual financial statements looked like:
2016 2017 2018
SALES 800,000 740,000 735,000
GROSS PROFIT 280,000 (35%) 259,000 (35%) 220,000 (30%)
EXPENSES 160,000 175,000 196,000
NET PROFIT 120,000 84,000 24,000
The owners saw the “problem” as being a drop off in sales and couldn’t understand this because, in their own words “we’ve never been busier”.
In 2016, a couple of new competitors opened up and grabbed some market share. The business held his gross margin in 2017 but lost $60,000 in sales revenue compared to the previous year. At the same time overhead expenses increased by $15,000 so the net result was a profit fall of $36,000.
The immediate reaction was to cut prices and to aggressively seek new customers. The owners decided to double advertising expenditure with an emphasis on “we won’t be beaten on price”. The strategy was intended to attack it’s competitors.
During 2018, they were pleased with the result. Sales revenue had stopped falling. Each week sales figures were compared with the same time in the previous year. The business knew it was winning the battle ...or so it thought. In 2018, the business was flat out, the employees were busy, the phone never stopped, advertising was getting tons of enquiries, but cash flow was poor.
When the end of financial year accounts had been prepared the owners were astounded that the business had only made $24,000. The figures must have been wrong. But they weren’t!
They were at a desperate stage. They couldn’t lower prices any more.
Some calculations were done after requesting some specific information, and this is what that turned up.
No. of Active Sales Gross Profit Sales Invoices
Invoices Customers per Invoice per Invoice per customer per customer
2016 2286 181 $350 $122 $4,420 13
2017 2651 205 $279 $98 $3,364 13
2018 3587 318 $204 $61 $2,311 11
As soon as they saw the figures, they could see exactly what had happened.
CAN YOU?
No wonder they were busy. The business had an additional 137 customers to look after and had an extra 1301 transactions to negotiate and process.
When you see this type of thing accompanied by a fall in revenue per sale and gross profit per sale it generally means only one thing. Service has fallen, prices have been cut and fixed costs have risen to handle the additional volume of business transactions.
When we dug deeper into his records he found that his top 20% of customers had been spending over $10,000 a year with him in 2016 but this had dropped to about $6,400 by 2018. In 2018, 80% of his active customers were actually only spending $1,290 with him.
What a pity he didn’t know about measuring then.
By concentrating on total sales revenue, they had lost the plot. Sure, they’d gained a lot of new business but most of it was rubbish. Most of the new customers were small, bad payers (which exaggerated the cash flow problem) and they were extremely price sensitive which the business had encouraged in it’s advertising. These new customers had influenced the owners thinking about the relative value of price versus service. Because they had a pre-occupation with price, they started to think all his customers were only concerned about price. The owners discovered in 2019 that this was not the case at all.
In 2019, the business did a complete turnaround. Prices were set to achieve an average 38% gross margin. The owners met with each of their top 30% of customers and they developed a customer service plan with their employees among other things.
The result in 2019 was staggering.
· Active customer count fell to 232.
· Average sales per customer rose to $3,420
· Gross profit per customer averaged $1,322.
· Net operating profit for 2019 was just over $97,000, up from $24000 in 2018.
There is nothing magical about this type of turnaround. By frequently monitoring the things that are important namely a measure of the volume of activity (in this case, the number of sales) and a measure of the dollar significance of this activity (in this case, sales value and average gross profit per transaction) you will be able to fine tune and direct your business exactly where you want it to go.