Five by Five – Module 2

THE ESSENCE OF PROFITABILITY

Have you ever heard the term ‘running on the smell of an oily rag?’ The essence of profitability in a business is effective cost control. Every dollar that goes into the costs of a business is a dollar that isn’t left in the business as profit.

Think about it. If you can maintain your customer service levels and quality on 10 % less costs, then all that saving will flow to your bottom line (profit). If you can procure your stock in trade for lower costs, then those savings will flow direct to your “bottom line” The flow of money into your business begins with payments from customers BUT the more that gets consumed with the expenses the less you will have left as profit.

While it can be really nice to have new equipment and fittings in your business, you must remember that your business is not your home. At home you make things as comfortable as possible. But in that environment you are a consumer. Comfort is often the key driver in this situation.

In a business, you are not there for comfort and lifestyle. Your prime objective is to generate returns in profits and cash flow which is why your attitude to cost must be entirely different.

Imagine all the hard work of getting a customer, convincing them that your product or service is what they want, and then finding that you make virtually nothing out of it! In fact, many businesses end up in this position; we call it “profitless prosperity”! Making lots of sales, lots of activity but with nothing to show for it at the end of the day. They increase their sales but never seem to have any additional money (profit) left over.

This is the reason why cost control is absolutely essential and a first step in obtaining business financial mastery.

The key to understanding cost control is to understand the nature of the different types of costs (or expenses) you have in your business:

There are basically two types of expenses in a business.

1. Expenses which vary with the volume of business and which are known as VARIABLE

2. Expenses which do not vary with the volume of business and are known as FIXED.

VARIABLE EXPENSES

Key Definition

Variable expenses are expenses, which vary relative to sales volume and so their key driver is sales volume.

An example of a variable expense in a business would be the cost of the product that you sell. For instance, if you are selling widgets in your business, then the more that you sell, the higher will be the overall cost of the widgets that you BUY in order to sell them. You may be able to negotiate a lower cost per unit with higher volume but the total expenditure will vary with the volume.

Variable expenses are less dangerous in your business because they are only incurred when a sale is made. Because there is revenue directly associated with each variable expense there will, in theory, always be the income to offset the expense.

FIXED EXPENSES

Key Definition

Fixed expenses are expenses, which do not vary relative to sales volumes.

Fixed expenses however are different. They occur whether you make a sale or not, so fixed expense are not driven by volume. A typical example of a fixed expense would be rent on your premises. You will find that the landlord wants you to pay the rent whether you make a sale of not. Many landlords do have some understanding of business and may grant a rent-free period to a tenant when they first come into the premises. However, there is no direct link between the sales and the rent. Rent is a fixed amount and does not vary with sales.

There is a different risk for variable expenses compared to fixed expenses. As a general rule, variable expenses are associated with getting product to customers. Often they form the COST of sales. As a result it is more risky to run these on “the smell of an oily rag” than fixed expenses which are generally not associated directly with servicing customers.

Whether you sit on a leather executive chair or an old apple box case will have very little bearing on your customer’s experience of dealing with you BUT it will have an effect on the profitability of your business.

Many opulent expenses are made for lifestyle or comfort reasons rather than business reasons.
Make yourself a promise that you will leave your lifestyle and comfort requirements at home each day and bring your business mindset to the business. Making good profits will allow you to have a better lifestyle AFTER making a success of your business and NOT before.

If you are starting in business after being an employee for many years do not expect the same conditions as when you were an employee. You will need to ‘tough it out’ while your business gets established and if you push too much expense into the business at an early stage it will negatively affect its performance.

Doing it a little tougher at the beginning will pay HUGE dividends in the long term and allow your business to be a success.

The biggest mistake to make is trying to look successful before you are successful and acting as though you are. Such pretence can only be sustained as long as you can borrow money BUT it will cripple you in the short term and possibly even be the cause of your business not surviving in the long term.

The essence of profitability is effective cost control, it is maximising the gap between your income and your expenses.