Many small business owners mistakenly believe that their technical expertise is the path to success. In reality, you can be the best master carpenter in the world, but without a meticulously thought-out blueprint, the building will never go up as planned.
Smart Business talked to J. Michael Rudd, director of client services for International Profit Associates, about the main factors that govern corporate profit.
What is the most important element of profit structuring?
The process begins by developing a strategic plan designed to increase your chances of success, not simply reducing the likelihood of failure. The plan must identify the business’ competitive advantage, dictate the direction of the company and provide a system to monitor profitability that is flexible enough to grow into the future.
How should a company be organizationally structured to maximize profitability?
A functional organizational structure is grounded in three categories common to all businesses: sales, operations and administration.
Sales is included because, without revenue, a business will fail. Operations is included because the business must perform what is promised when it is promised. Administration is included because a business must have the ability to track key variables, and measure the success or failure of plans, activities and the people involved. You must measure it in order to manage it.
What is the best method of controlling cost?
The business owner must create a system wherein the employee is motivated at all times to exceed defined performance standards with an excessive profit-based incentive program. This program insures the employee will have something to gain or something to lose directly tied to his or her actual performance. Three specific things must be taken into consideration.
- The incentive must be based upon specific measurable criteria and be shared in some way among all employees. The amount each employee receives is based on the direct impact that employee has on profit.
- The incentive must have a positive and negative component, and the impact (positive or negative) cannot be the result of a one-time windfall or disaster.
- The incentive must be paid often enough to consistently motivate the employee, but not so often that it becomes a burden on administration or is taken for granted.
How can a business monitor its profitability?
A financial reporting system based on the company’s Strategic Plan must be put in place. This report must identify the critical variables within the company by developing a profit-and-loss (P&L) chart of accounts, which includes revenue, direct job costs, margin contributions, indirect overhead, and general and administrative expenses.
Revenue: Not all sales are the same in that some products or services are more profitable than others (due to competitive pressure, purchasing leverage, etc.). These facts taken into consideration as separate revenue categories are tracked and specific goals are set for each to assure a balanced revenue stream.
Direct job costs: The direct costs of the company are variable (such as labor, labor burden, subcontracting, equipment rental, waste, materials, warranty expense, commission and royalty expense; and, in the case of large equipment operators, fuel and oil for the equipment, etc.). This means that as revenue increase, these costs must increase proportionally.
Margin contributions: The difference between revenue and direct job cost is margin contribution (gross profit), which is the amount of money the business has in place to pay the rest of the company’s expenses.
Indirect overhead: Indirect overhead expenses are related to the execution of the activity, but are not allocated to the company’s variable cost (such as supervisor and estimating wages, small tool expenses, supplies and fuel, oil, transportation and training expenses for a contractor; sales salaries, warehouse labor, warehouse supplies, shipping supplies and equipment expenses for a stocking distributor).
General and administrative expenses: G&A expenses are the overhead categories that continue regardless of revenue (such as accounting, bank fees, rent, utilities, depreciation, interest expense, owners and administrative wages, and associated burden).
The combination of indirect overhead and G&A subtracted from the margin contribution is the operating profit.
How does the business owner tie the pieces together?
In order to realize profit potential, a business owner must understand that nothing stands alone within the business and every decision has an impact on profit. Each business is unique in its cost structure, employee and management profile and market. Business owners must follow the principals of sound business management and learn to utilize the aforementioned management techniques, which are customized to their specific business requirements.
MIKE RUDD is director of client services for International Profit Associates of Buffalo Grove, Ill. IPA’s 1800 employees offer consulting services to businesses throughout the United States, including Alaska and Hawaii, as well as Canada. Reach Rudd at (800) 531-7100 or [email protected] or at www.ipa-iba.com.