Profit Drivers

One of the toughest challenges that companies face is learning how to manage financial outcomes before they happen vs. simply measuring them after they happen. The way to do this is to focus on drivers.

What is a Driver?

A driver is anything that controls the outcome of something else (in this case, profit). Consequently, understanding the things that drive your company's profitability will enable you to focus your attention on the areas that have the greatest financial payoff.

Key Profit Drivers

For most businesses, there are four major profit drivers: 1) price, 2) variable costs (i.e. those costs that vary in direct proportion to revenue and which typically are represented by cost of sales), 3) the physical volume of sales (i.e. the number of transactions), and finally 4) fixed costs (or overhead). You can think of these four issues as "levers" that can be used to manage your company's financial performance.

The Importance of Price

Which leads to an interesting question: Do all of these drivers have the same impact on profit? The simple answer is: no. In fact, price will always have a greater impact on profit than any of the other drivers, and usually that impact will be in the order of two to three times the effect. The reason for this is quite straightforward: an increase in price has the greatest impact because every additional dollar goes straight to profit. By comparison, an increase in volume will be accompanied by an increase in variable costs, so gains will be small. A decrease in variable costs will increase the margin but will not increase overall revenue. Finally, a reduction in fixed costs (i.e. overhead) has no impact on revenue and therefore will always have the smallest impact.

You might be thinking, "That's all well and good in theory but if I increase my prices by 10%, how much business would I lose?" That's a good question but a far better one is, "How many customers could I lose and still make the same amount of profit?" The answer might surprise you. For example, it is entirely possible that a company which raises its prices by 10% could lose 25% of its customers and actually be better off. In other words, the company would make the same or greater amount of profit despite losing a quarter of its customers.

Two Classic Mistakes

The strategic implications of this type of analysis are very important. Many business people are preoccupied with getting more revenue, often from new customers.  They pay very little regard to the customers they already have and usually adopt the view that price is something over which they have very little control because of competitive pressure (classic mistake #1). They also believe that reducing costs is the most effective way to building a profitable business (classic mistake #2).

This is absolutely the wrong way to run a business. Even though it makes intuitive sense that cost reduction leads to improved profitability, there is a big qualifier to this. If a cost is necessary for you to do business, then reducing it may reduce your capacity to do business. Furthermore, the costs that can be reduced most easily are generally those of a "discretionary" nature and these tend to be the ones geared toward building the future of your business (marketing, team training, R&D, etc.). A more useful strategy is to constantly review your costs and ask, "What are getting for what we're investing here? Is there a way for us to be more productive?"

Conclusion

The bottom line is this: far and away the most effective strategy for maximizing your company's profit is to aggressively price your products or services, elect to deal only with those customers who see and accept the value that you deliver to them, and not allow customers (or competitors) who are price-sensitive to dictate your company's pricing strategy across the board. Concentrate less on quantity of revenue, and more on quality. At the end of the day, profit is the only measure of success. Revenue does not pay the bills or give you the resources you need to grow- that comes from profit.