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Making Margins: What Is the Right Formula for Profitability?

General Business News

June 2014

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Making Margins: What Is the Right Formula for Profitability?

Every day it seems like the cost of everything is going through the roof. How do businesses know how to charge the right amount to pay overhead and still make a profit? Understanding what factors business owners have to consider to stay profitable is essential not only to survive, but to thrive in today’s competitive global economy.

According to a May press release by SageWorks.com, the Accounting, Tax Preparation, Bookkeeping and Payroll Services, and Legal Services industries are the second and third most profitable industries with 21.2 percent and 19.6 percent net profit margins, respectively. With 10 percent of startup owners working 70 hours a week, losing sight of a business’ main goal of profitability is quite easy, according to Forbes.

Labor Costs

According to the Bureau of Labor Statistics, the official U-6 unemployment rate at 12.3 percent. With this in mind, businesses might be forced to keep prices as low as possible. This could include keeping prices constant or minimally raising them, despite rising commodity prices. How would a business owner maintain profitability despite rising input costs? One way is to reduce labor costs per unit or service delivered.

Illustrated by Mind Tools, looking at how efficiently an item or service is produced and delivered can help increase efficiency and profitability, despite an initial labor investment. Increasing efficiency by as little as 10 percent (from 30 to 27 minutes) with a $500 additional investment for a maintenance manager and $2,000 to produce 675 widgets instead of 300 in a week’s time-frame, can significantly reduce labor costs. Assuming Mind Tools’ $12 hourly rate, the labor savings would be 60 cents per unit or $405. This savings, coupled with reduced shipping and raw material costs, will create a greater profit margin through a higher volume of items sold or services delivered.

Overhead

Whether its fixed costs, such as rent for a year-long lease, or variable costs, such as the price of heating or cooling, there are ways businesses can increase profitability. If you own the business or are tasked with orders from the owners to cut overhead, it is necessary to do this strategically. According to Harvard Business Review, cutting costs by as much as 10 percent can be accomplished with little impact through Incremental Ideas. Two examples include creating interdepartmental training and celebratory events. Whether it’s training for new software, sales, or customer service practices, combining necessary business functions with social team-building events saves money while boosting worker morale.

Margins

One type of margin that is essential for any type of business – especially startups – is gross margin, according to the U.S. Small Business Administration. Defined by the SBA as the difference between the product’s or service’s selling price minus the fluid costs (including labor, electricity, and raw material costs), it helps business owners determine how efficiently they are running the shop. Businesses that analyze their production process can see how much their raw materials cost, how much their internet and electricity cost, and how long it takes employees to complete a task. It is important to conduct this analysis because sometimes you can find a lower cost raw material, electricity, or internet service provider to perform the same task.

Using creative methods to reduce labor costs, trim overhead, and increase profit margins is essential not only to grow one’s business but, when optimized, can lead a business to thrive even in the worst business environment.

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These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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