How To Increase Profit

In our last post we discussed the four factors which determine profit. Today you’ll see how you can manipulate those factors to increase your profit.

How To Increase Profit

If you’re looking for ways to increase your profitability, you have to focus your attention on the 4 profit-determining factors: price, volume, variable costs, and fixed costs.

Let’s look at each of these 4 factors under 3 headings—the factor, the possible action you could take to enact change, and the required conditions that would have to occur to increase profits.

It’s important to note that profitability can be increased by taking action to increase or decrease any of the 4 factors, as long as some conditions are met.

 

Factor	Action	Required Conditions
Price	Increase	Sales volume could either remain unchanged or decline. If sales volume declines, the decline would have to be less than the offset created by the price and resulting profit increases.
	Decrease	The sales volume would have to increase sufficiently to compensate for the decline in price. If sales volume increases as a result of the decreased price, there is a possibility of a decrease in the per-unit fixed and variable costs because of increased economies of scale.
Variable       Costs	Increase	The increased variable costs should lead to or be a result of improved product or service quality. The market would have to accept a higher price, or the heightened quality would have to attract enough new buyers to offset the increased variable costs.
	Decrease	The sales volume would have to remain unchanged. The decrease in variable costs could not be allowed to affect product or service quality, which would have a consequential effect on sales. If they did decline, the fall in gross profit would have to be less than the decreased variable costs.

 

 

Sales           Volume	Increase	The price could either remain unchanged or decline. If the price were reduced, the reduction would have to be less than the offset created by the volume and resulting profit increases. Another possibility is to achieve a reduction in per-unit fixed and variable costs due to increased economies of scale.
	Decrease	A savings in fixed costs would have to be achieved by reducing the size of the business, or production levels would have to be evaluated to find variable cost economies of scale. This savings would have to be greater than the reduction in gross profit due to the decreased sales volume.
Fixed           Costs	Increase	The increase in fixed costs should lead to or be a result of improved product or service quality. The market would have to accept a higher price, or the heightened quality would have to attract enough new buyers to offset the increased fixed costs.
	Decrease	Sales volume would have to remain unchanged. The decreased fixed costs could not be allowed to affect product or service quality, which would have a consequential effect on sales. If they decline, the fall in gross profit would have to be less than the decreased fixed costs.

The interesting thing to notice about the previous summary is that no single factor can be considered without considering its impact on, or the impact from, each of the other factors.

The second thing to notice is that a profit improvement strategy may involve either an increase or a decrease in each of the 4 factors. There is no standard formula for improving profitability; it depends entirely on specific circumstances and the relative strengths and weaknesses of your business.

The third thing to notice is that a favorable change in price and/or your variable costs improves your gross margin per dollar of sales. On the other hand, a favorable change in your sales volume and/or your fixed costs indicates greater productivity. Therefore, the overhead you incur in running your business involves lower costs per dollar of sales.

In other words, any profit improvement strategy must focus on either or both of 2 things:

1. Achieving a higher gross margin per dollar of sales by increasing price and/or reducing variable costs.
2. Achieving greater sales per dollar of fixed costs by increasing the productivity of those things that have a fixed cost.

So that we can put everything into perspective, let’s consider the profit improvement potential that would arise from a modest improvement in each of the 4 factors.

We’ll use these figures as a base. To demonstrate the powerful effect of small changes, we’ll make a 5% improvement in each of the 4 factors.

 

	Base	% Change	Result
Price	100	5% increase	105
Sales Volume	100	5% increase	105
Total Revenue	10,000		11,025
Variable Costs ($60)	6,000	5% decrease ($57)	5,985
Gross Margin	4,000		5,040
Fixed Costs	3,000	5% decrease	2,850
Net Profit	1,000		2,190

 

It can be seen that a 5% favorable change in each of the 4 factors, without a consequential unfavorable impact on the other 3, would more than double your profit (from $1,000 to $2,190)—a 119% improvement.

You may take issue with the assumption that there are no consequential impacts. However, it’s a fact that small improvements made to each of the 4 factors which determine your profit combine to give a staggering overall impact.

And, of course, the reverse is also true. If you discount your price, allow your sales volume to fall, fail to control your overhead costs, or let your variable costs get away from you, you can destroy a potentially profitable business. This can happen very quickly.

You see, it’s all about what we call leverage—a concept that can make or break a business. If you get all the little things right, the big picture looks after itself. But if you get all the little things wrong, you’re going to be in real trouble (and it’s likely, you’ll never know why).

This was part two in a series.

Part 1: What Is Profit?

Part 3: Improving Your Gross Margin

Part 4: Improving Productivity