Managing Profitability to Maximize Your Profit

What is profit, and what do you mean when you say that you operate a profitable business? How do you measure profitability, and what good comes from doing so?

Ask business owners what they gain from their labors and you get a number of answers, among them the satisfaction that comes from creating something bigger than themselves, the desire to act decisively in the world, even the simple joy of competing in the marketplace.

But commerce creates no good of any kind before it creates profit.

As outlined in this space recently, profit is the surplus of revenue over expenses, including taxes and such noncash expenses as depreciation. You measure profit with a profit-and-loss statement, also known as the income statement, which analyzes revenue and expenses over a given period of time--the last month, the quarter, six months, the year.

Profit and cash flow are akin but different. Cash flow is what you have left after you pay your cash expenses at the end of a given period of time. You measure cash flow with the cash flow statement, which shows the movement of cash in and out of your business over that time.

Profit and profitability are also akin but different. Profit is the end of your business activity. Profitability is the means to that end--in the sense that you must operate profitably if you want to end up with a profit. In a very real sense, profitable activity creates profit at the end of the day.

Business owners, confusing profit and profitability, sometimes look at a P&L; statement and go no further, according to Howard Reiss, a certified public accountant, consultant and former business owner who lives in Huntington Beach.

But at best your P&L; statement tells you whether you operated profitably in the past, Reiss says. Often it tells you about a past so distant as to be meaningless.

The better idea, he adds, is to measure your profitability every day--indeed, to measure the profitability of every sale you make.

How?

“The P&L; statement is like a scorecard, and if you don’t have one, it’s like playing golf and not keeping score,” says Reiss, who was a partner in an accounting firm and for 10 years owned his own manufacturing and distribution companies in New Jersey.

“It tells you how much money you made and, if it’s well laid out, it tells you why you made or lost it.”

In running his companies, Reiss studied rolling 12-month comparative P&L; statements--that is, statements comparing the result of the current month with those of the 11 preceding months.

“If I started my fiscal year in January and I looked only at January’s results, I learned nothing,” Reiss says. “But if I looked at the results from January of this year through February of last year, I could see whether sales expenses, for example, had gone up or down, and do something about them.

“If you just look at those numbers at the end of every quarter, it’s usually too late to do anything about them.”

Reiss also analyzed gross profit over rolling 12-month periods. With his distribution company, he defined gross profit as selling price less material cost; as a manufacturer, he defined it as selling price less direct labor, material and factory overhead.

He even analyzed gross profit by product, customer and salesperson--easily done, these days, by computer.

“We distributed packaging products bought from big companies like 3M and sold to other big companies in the New York area,” Reiss says. “What could be more boring than that? And there were 10 other distributors in the area who sold to the same customers.

“But when we sold our company, we had the highest gross profit in the industry. How did we do it? By selling the most profitable product to the most profitable customer through the most profitable salesperson.”

Put another way, Reiss’ reports told him which sales made by which salespeople to which customers generated the highest gross profit. Armed with this information, he managed his profitability so as to generate the biggest profit.

“We shipped every day,” he says, “and we tracked the profitability of every shipment before it went out. If a customer held off payment, we knew it would cut into profitability, and at some point we asked the customer to pay sooner or pay more. Ninety-nine percent of the time we didn’t lose the customer because our service was excellent.”

Similarly, he studied daily “exception” reports analyzing any deviations from the norm--for example, delays in payments from customers who ordinarily paid on time, or downturns in the productivity of his salespeople.

The goal, he says, was to run his businesses profitably every day.

“Sixty to 70 cents of every dollar goes to making or buying your product,” he says. “Gross profit is what’s left over, and you don’t need to change gross profit much to make a big difference in the bottom line.

“Every 1% improvement in your profit is $10,000 on each $1 million in sales. It usually takes several hundred thousand dollars in new sales to generate that much profit. Which is easier?

“If you get timely and useful information in your reports, you can use it to leverage your experience into running your business most profitably.”

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Columnist Juan Hovey may be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.