Businesses fail for complicated reasons — from dysfunctional management to insufficient capital; too-rapid growth to an inability to respond to changing markets. Why businesses succeed, on the other hand, is often easily explained. Regardless of size and sector, most healthy companies share three characteristics: 1) strong revenues, 2) low production costs and 3) low operating expenses. Here’s how to achieve them.
Revenue paving the way
To determine how much revenue your company needs to be profitable, perform a profitability breakeven analysis. (See the last section “Crunching the Numbers” below). The results provide a baseline for setting revenue goals.
If you calculate your profitability breakeven point and find you may fall short, review your sales and determine where you can make changes. For example, you may need to invest more in R&D or focus more on prospective customers.
Production costs in check
For most companies, labor is their biggest production cost, particularly when benefits and taxes are factored into the equation. You need to ask whether your labor force increases the value of products or services enough to offset its high cost. If not, consider such solutions as providing more training or better incentives, improving production processes, or investing in more modern facilities.
To keep materials costs in check, use cost management software. It can help you evaluate materials purchases, measure optimal ordering quantities and reduce waste.
Finally, keep an eye on production overhead. Many businesses mistakenly allocate production overhead costs based on sales volume. Say, for example, a product accounts for 25% of sales volume, yet it uses 50% of plant space. Production overhead makes it less profitable than its sales numbers would suggest.
When production overhead costs are too high relative to a product’s sales price, take action. You might increase the price of the product, find better production methods or even discontinue the product.
Toward leaner operations
Operating expenses — costs you incur to run your business that aren’t directly attributable to production — also should be minimized. For example, compensation takes a big bite out of your operations budget, so monitor staffing needs relative to sales and adjust staffing levels when necessary. And while you can’t eliminate marketing expenditures, you can review your sales levels relative to them and ensure you’re getting bang for your buck.
Also, regularly revisit your R&D budget and the progress you’re making toward established goals. Are you squandering resources on projects unlikely to come to fruition? It may be time to redeploy resources.
Establish a foundation
A company with strong revenues, low production costs and minimal operating expenses can still fail due to poor management decisions and other pitfalls. But if you’re trying to build the foundation for a healthy, long-lived business, start by focusing on these three keys.
Crunching the numbers
Every business should regularly perform profitability breakeven analyses. At its most basic, the formula is:
Operating expenses + interest expense
gross profit margin
So if your operating expense is $500,000 and your interest expense is $50,000, a gross profit margin of 25% would require $2.2 million in sales for you to break even. Your accounting software should be able to calculate more sophisticated analysis based on various scenarios.
