The four factors that affect your profit
If you’re looking for ways to increase your profitability then you have to focus your attention on the four profit determining factors: price, sales volume, variable costs and fixed costs.
Let’s look at each of these four factors under three headings – what factor, what possible action you could take and what conditions would have to occur. It’s important to note that profitability can be increased by either taking action to increase or decrease any of the four factors, as long as the required conditions are met.
Either: no change in sales volume or if sales volume declines, the decline is more than offset by the increase
in price so that the total revenue is still increased.
Sales volume increases sufficiently to compensate for the decline in price and/or new customers are won who
will be retained in the future as and when price is increased to normal.
Factor: Sales Volume
Price remains constant so the increase in volume translates into higher gross profit.
A saving in fixed costs is achieved by reducing the size of the business and the saving is greater than the
reduction in gross profit.
Factor: Variable Costs
No change in product or service quality which could have a consequential effect on sales.
Improvement in product or service quality allows a higher price to be charged which is both accepted by the market and which is sufficient to offset the higher variable cost.
Factor: Fixed Costs
Sales remain unchanged or if they decline, the fall in gross profit is less than the decline in fixed costs.
Sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs.
The interesting thing to notice about the above summary is that no single factor can be considered in isolation without considering its impact on, or the impact from each of the other three factors. The second thing to remember is that a profit improvement strategy may involve either an increase or decrease in each of the four factors. There is no standard success formula, it depends entirely on specific circumstances and the relative strengths and weaknesses of your business.
The third thing to notice is that a favourable change in price and/or your variable costs will improve your gross margin per dollar of sales. Whereas a favourable change in your sales volume and/or your fixed costs indicates greater productivity. That is, the overheads you incur in running your business are lower per dollar of sales.
In other words any profit improvement strategy must focus on either or both of two things:
- achieving a higher gross margin per dollar of sales by increasing price and/or reducing variable costs.
- achieving greater sales per dollar of fixed costs by increasing the productivity of those things which have a fixed cost.
So that we can put everything into some sort of perspective let’s consider the profit improvement potential that would arise from a modest improvement in each of the four factors. Let’s consider the case of a 5% improvement in each of the four factors:
Base Change Result
Price 100 5% increase 105
Sales Volume 100 5% increase 105
Total Revenue 10,000 11,025
Variable Costs ($60) 6,000 5% decrease ($57) 5,985
Gross Margin 4,000 5,040
Fixed Costs 3,000 5% decrease 2,850
Net Profit $1,000 $2,190
It can be seen that a 5% favourable change in each of the four factors without a consequential unfavourable impact on each of the other three would more than double your profit from $1,000 to $2,190. This is a 119% improvement!
You may want to take issue with the assumption that there are no consequential impacts. However, it is a fact that small improvements made to each of the four factors that determine your profit will combine to give a staggering overall impact. And, of course, the reverse is also true. If you discount your price, allow your sales volume to fall, fail to control your overhead costs and let your variable costs get away from you then you can destroy a potentially profitable business. This can happen very quickly.
You see it’s all to do with leverage and this is what brings so many people unstuck. If you get all the little things right, the big picture looks after itself. But if you get all the little things wrong you’re going to be in real trouble and it’s likely you’ll never know why.