This week I spoke to a new client who contacted me through the EAdvice service on my website. In her written correspondence she expressed concern about the overall profitability of her company. Of course, those were not the specific words she used in her email. Rather she wrote the words I hear many business owners proclaim, “Although I continue to get new clients I still do not have enough money to support my business yet alone my personal expenses”.
She recognized the issue but was not sure of the best solution. She wondered if she should invest additional money in marketing to increase the amount of customers. She was also considering hiring a lower wage person to take on some of her daily task thinking that would lower the cost.
Here’s why you should fire some customers
Often business owners believe the answer may be to simply increase sales. However, if current sales are not yielding enough profit to cover both production and operating expenses then increasing the number of transactions may not increase profitability. Moreover, if the staff is already working at capacity and the company is not yielding profitable returns, hiring admin support may not be the answer either. This is especially true in service based companies where the addition of a customer will require an equal increase in time.
What’s the Correct Answer?
First you need to fully understand the profitability parameters that you must work within. This includes knowing the Gross Profit Margin and the Net Profit Margin. The Gross Profit Margin identifies the profit from sales after subtracting the cost to produce. The Net Profit Margin identifies the remaining profit after overhead has been deducted.
If the Gross Profit Margin is not sufficient to cover overhead then you have three options: increase the selling price, decrease the cost to produce or reduce the overhead expense. Each of these solutions (or any combination) requires further analysis. Specifically, the market may not bear higher prices, production cost could be fixed as well as some of the overhead cost. Nevertheless, you will need to make changes in one or all of the areas.
Assessing Customer Profitability
The next step is to rank customers according to their average Gross Profit Margin. This is defined by calculating the total revenue and subtracting total cost for all sales within a defined time period.
Once the customers are listed by their Gross Profit Margin, the ones that are at or above the Gross Profit Margin are distinguished from those that fall below. For example, based on the company’s financial structure if the Gross Profit Margin target is 45%, all customers below that amount should be reviewed. This analysis can be used to separate those customers that add to the bottom line from those that actually cost the company money.
Armed with this information management can (1) review the customer relationship to determine the reason they are not profitable, such as for discounting, excessive use of customer service, customized orders and/or extra services that are not added to the price (2) set better customer policies that will address the issues identified (3) consider discontinuing service to the least profitable customers (4) use customer profiling to identify new customers similar to those that are profitable.
About the writer: Lori Williams
Lori Williams is a well-known business consultant, speaker and writer. She is the founder of www.BusinessSimplyPut.com which is an online resource for business information and advice. Business Simply Put offers eBooks, Financial Tools, Webinars and Videos designed for start-ups and small businesses. Lori is also an adjunct professor for Entrepreneurial Studies at the University of Southern California.
For a more detailed description of the process including other performance measurements visit www.BusinessSimplyPut.com. Click on eBooks or Videos for information specific to this topic.