How to Apply Business Profit Analysis and Planning Principles

In my previous articles, I have discussed in detail the fundamentals of the income statement and how to analyze an income statement to maximize profits, along with a step by step process on how to plan for profits. To pull this all together, I will give some examples of how good profit analysis and planning made for a company’s success and the flip side of that scenario (and the reasons why the companies were unprofitable). I will present three scenarios of manufacturing companies which had good profitability, mediocre profitability and one which failed. All three companies are in the same industry.

Successful Company: Company A

In examining Company A’s Income Statement, there are many clues as to why it was a successful company:

– Market: Established a market by determining a market need and effectively filling that need. In a five year period sales grew from $11K to $60m in relation to a market that grew from $413M to $510M.

– Expenses: Expenses were reduced as a percentage of sales over the years, with Engineering and Sales Expenses at year 5 three percentage points below the industry average. The lower engineering costs were attributable to high caliber engineers who designed a superior product which required fewer development changes and allowed employees to concentrate on innovation in the subsequent years.

– Marketing Costs were low due to using a network of Distributors to sell the products rather than using a large sales force and manufacturing reps. The small sales force was used to concentrate on high volume accounts, giving the company a big return for its investment in its sales people. This alone added 7 percentage points to its bottom-line profits.

– Cost of Sales was maintained at 62% of sales during the 4th and 5th years of operation which provided a 38% Gross Margin. This GM is about 10% above the average Break Even Point for similar companies, giving Company A a good cushion of profitability.

Mediocre Company: Company B

Company B was a six year old company and located in a region of the country that offered lower labor and overhead costs.

– Sales Success: Company B had very aggressive pricing strategies and undercut its Competitors to achieve large volume orders. Profit was not the motive; dominance was the underlying strategy.

– Aggressive Pricing: In relation to its closest competitor, Company B’s sales were three times larger, material costs 15 percent lower and labor 5 percent lower.

– Overhead: This is where Company B made its mistake. Overhead expenses were 27%, causing Cost of Sales to increase to 76%, leaving a Gross Margin of only 24%, which was Break-Even in the best of circumstances when accounting for Engineering, Marketing and G&A. This was a ripple effect which greatly reduced Company B’s profitability, causing the parent company to sell it. An acquiring company quickly corrected the Overhead issue and installed a new General Manager to institute better profitability controls, which helped it recover over time.

Company Failure: Company C

Company C captured 27% of its market, yet failed to stay profitable.

– Management: Plagued by severe management problems.

– Spending: Flamboyant and expensive habits.

– Product: Poor Design and low manufacturing quality.

– Staff Reduction: As a result of poor management, financial losses and product failures, Company C reduced its staff of 600 to 400 employees. The Company subsequently fixed its design issues, increased its market share from a significantly lower share of 2% to 4% and grew employment to 150 employees. The Company was climbing back and barely keeping its head above water.

– Turnover: Company C experienced severe top-management problems, and as a result, lower-management, along with the technical and production ranks, suffered from excessive employee turnover. In a year period, employee turnover was over 100%. Company C as a result experienced a bad reputation in the Region’s labor pool causing it major difficulties in attracting quality employees. As a result of its low quality labor force, Company C’s product quality declined and customers were lost. The high employee turn-over created a situation that made it impossible to reduce product costs. Company C was constantly in the training mode and the domino effect of catastrophic events forced it to cease operations.

– The Numbers: COGS amounted to 84%, leaving only 16% for Engineering, Marketing, G&A and Profit. This is clearly out of whack by 20%. Material Costs totaling 53% could not be reduced due to high employee turn-over, which created a loss of purchasing continuity and poor procurement strategies. Slow payments to Suppliers contributed to higher material costs since the suppliers increased their prices to compensate for the added costs of doing business with Company C. Company C strove to make improvements, but the improvements were made in the wrong places. Labor Costs were reduced from 8% to 4% and overhead from 10% to 5%, using the same products and predicting inflation rate of 13%. G&A at 3% was reduced dangerously low. The combination of indiscriminate cutting of costs, poor labor quality, poor product quality and very expensive material costs ultimately combined to doom Company C.

What can be Learned?

By applying Profit principles I have previously discussed (namely, Income Statement Fundamentals, Profit Analysis and Profit Planning), I showed companies successfully and unsuccessfully applied these profit principles. The Income Statement is a good place to start your Profit Analysis as it shows how a company has spent its money in years past and what it projects its spending to be in the future, along with whether the proportions of its revenue streams and expense / cost levels were healthy or unrealistic.

By understanding what an Income Statement is telling you, how to properly Analyze it for maximum Profits and how to successfully and realistically plan for Future profits, you can significantly increase and sustain better Cash Flows. However, the process should not stop here. As you have planned to Maximize Business Profits and implemented it successfully through your company’s Strategic Plan, Cash Flow Management becomes the next step in the Profitability process.

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