I believe there are 3 sequential steps to take in making a business profitable:
First – Go for Turnover. Don’t worry about your costs. If you don’t have turnover, you don’t have a business. Simple. You need to understand what your customers will buy from you and test how much they will pay. And you’ll need to carefully evaluate the results.
Second – Go for Gross Profit. If you are selling a tangible product, then it will have a cost (called a Variable Cost or a Cost of Sales). If you are selling a service, then your Cost of Sales might be negligible. Subtracting the cost from your price gives you your Gross Profit. Expressing this as a % of your price gives you your Gross Margin. This needs to be a positive number if you’re going to make money.
Third – Go for Net Profit. This is calculated by subtracting your Fixed Costs from your Gross Profit. Your Fixed Costs are the things you pay for whether you're making sales or not. They'll include your rent, service charges, broadband, fixtures, equipment, salaries, marketing costs, intellectual property, travel and subsistence, in fact everything that is not an expense directly required to make your product or service.
Let’s look at an example, using some very low numbers:
Two companies have the same Turnover of £100 and Company A has a lower Cost of Sales, and therefore a higher Gross Profit. However, Company A has Fixed Costs that eat all the Gross Profit and so the Net Profit is zero.
On the other hand, Company B makes a small Net Profit of £10, because, although their Gross Profit is lower, so are their Fixed Costs.
Which of the 2 companies has better profitability and might be considered a better investment opportunity? Some might say Company B, because it actually makes some Net Profit.
But look what happens when Turnover increases by 10x for both Companies, with all other factors being the same:
Company A becomes the more profitable, and by a big margin – Why? Because its Cost of Sales is lower and so its Gross Profit is higher. A Gross Margin of 50% compared to 30% is a big difference. And Fixed Costs have remained the same.
Company A now has the better financial performance and is arguably the better investment opportunity.
Of course, people will shout that this is too simplistic, and they will be right. There are other variables to consider. Bigger volumes might mean having to sell at lower prices, or it could mean negotiating a better cost of sales. Fixed costs might increase because of the need, for example, to spend more on marketing, or people. There could be lots of changes.
But the basic premise is correct – focus on Turnover, then Gross Profit and then Net Profit to build your unicorn.
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