When business owners look to increase profits, they often opt to lower product prices or cut overhead costs. The problem is that these methods do not address internal profit challenges that may be lurking within the company. One way to ferret out these problems is to segment the business data, says David E. Shaffer, CPA and director at the accounting firm of Kreischer Miller.
“It’s much easier to analyze a company’s profits if you break the data into smaller segments,” says Shaffer. “Once the data is segmented, it often turns into information that an owner can use to make good business decisions about increasing profits.”
Smart Business spoke with Shaffer about the way businesses traditionally make decisions about increasing profits, and how using segmented business data is a more effective alternative.
Could you explain why you believe cost-cutting or lowering prices is not a good solution to increasing profits?
Cost-cutting, while beneficial in the short-term, is not a viable long-term strategy because it ultimately damages current customer relationships since it reduces the ability of the company to meet customer needs. Overhead costs are important investments that allow the company’s profits to grow. Lowering prices is not a good alternative because this means that volume needs to increase in order for profits to remain the same or increase.
The better alternative is to segment and analyze the company’s financial data. If you look at a company’s financial statement, you can determine the company’s gross profit percentage, which is just an average. What most business owners want to do is figure out how to increase this average. This is where business segmentation comes in and becomes a powerful tool.
What is business segmentation?
You can slice, or segment, good data in a number of ways.
For instance, you can segment the gross profit by customer, by product, by customer annual sales, by product annual sales, by channel, by market or by geography. Often, when this is completed, an owner finds that 80 percent of the profit is coming from 20 percent of the sales (the 80/20 rule).
For example, let’s say 49 percent of XYZ’s customers bring in a gross profit below $750 and 7 percent of the company’s customers have sales or gross profit greater than $5,000 per year. The question is: should a company treat these two customers equally? This, of course, is a management decision. And an important one if a company is looking to increase profits.
How can a business owner use this business segmentation to increase profits?
Once the data is analyzed, the business owner and managers need to look at the smaller clients and determine what to do with them. Should these customers be dropped? Should there be a prepay option (which eliminates collection costs) or other special provisions that increase the gross profit coming from these smaller clients? These are options that the business owner and management need to carefully consider once the data analysis is completed.
It seems like a lot of judgment calls need to be made once the data is segmented, is that correct?
That’s right, because sometimes just looking at the hard data is not enough, and the business owner needs to dig deeper to find the real story of its profits.
For example, the invoice cost of a product may not necessarily be the true cost. When 20 percent of a distributor’s products arrives damaged and spoiled, the average cost per product sold should be increased by 20 percent if the items cannot be returned.
Another example is freight costs, which are often allocated to products based on purchase price; however, this may not be indicative of the true costs. Large, lower-cost items shipped in from abroad are most likely not absorbing the fair share of the freight costs, while higher-priced, smaller items are probably absorbing too much.
What are some other incorrect assumptions that can be made about the segmented data?
In keeping with the above example of XYZ company: 7 percent of the customers have gross profits in excess of $5,000 so one would think all of these customers should be treated the same. What if one of these customers has 3 orders per year and the other has 3,000? What if one returns 10 percent of the shipments and the other never does? What if one pays within 10 days and the other takes 90 days (and getting longer). Typically, just looking at the gross profit dollars does not give the full picture.