What you think you want ain’t necessarily what you need.
In a previous role, I used to help companies turn around their bottom line financial performance.
Nearly always, at the start of the assignment, the client would say something like “I know we’ve got a good business here. We just need to make more sales, then everything will be fine.”
And, nearly always, that wasn’t actually their problem.
That approach kinda makes sense as far as a P&L goes – mathematically if you increase your revenue line and keep all your other costs the same, your bottom line increases.
But, for a really good CFO, your P&L is only part of the picture. And not even a very big part of the picture at that.
For one simple reason. By the time something lands on your P&L, it’s already happened. You can’t do anything about it. P&Ls just report on history.
And while that’s valuable in many ways, if your P&L isn’t where you want it to be in bottom line terms, there’s very little point spending more time analysing your P&L. That’s not where your problem is.
Your problem lies “upstream” of your P&L.
Swimming upstream
There were some financial analytics I used to do first, just to get the lay of the land, but generally my first port of call was the company’s gross margins.
Because if you want to grow your bottom line, you’re extremely unlikely to be able to do that if your gross margins aren’t high enough.
So, quite quickly, I’d generally move the conversation from a pressing need to do something about the bottom line, through a conversation about needing to “sell more”, to the real issue which was that the gross margin wasn’t high enough to cover the company overheads and leave a profit.
Now, there are two important caveats here.
Firstly, you need to make sure the gross margin is calculated correctly – which in an amazing number of businesses it isn’t. That’s a topic for another day, but if the gross margin which shows up in your P&L isn’t a true gross margin, all your decisions from that point onwards will be sub-optimal at best, and will quite likely make things worse.
Secondly, what I’m talking about here is your gross margin in cash terms, not in percentage terms.
There is absolutely no certainty that a business with 80% gross margins (assuming they calculated them correctly, of course) is a more profitable business in bottom line terms than one with 20% gross margins.
Sure 80% margins make it sound like you’re a business mastermind, but if your 80% gross margins translate into a gross profit of £1million and your overheads are £2million, you’re not going to solve your bottom line problem any time soon, even if you get that 80% margin up to 90% or 95%. The maths just doesn’t work.
In the interests of balance, the other common option at this point is to take an axe to that £2million in overheads.
I’m not for a moment saying that’s never the right answer – occasionally, when a company is in deep financial distress, there’s no other option to steady the ship fast enough – but taking an axe to overheads before you’ve fully understood what’s going on at gross margin level will often take you in the wrong direction too.
Especially since the process of really getting to grips with how your gross margin works, when done well, only takes a couple of weeks. We’re not talking months or years here.
Unless the liquidator was in the car park, I used to counsel clients to hold their nerve for a couple of weeks to make sure they weren’t going to make decisions they might come to regret, or decisions which would have long term cost implications much greater than any short-term benefit.
Going incremental
The most important question to know the answer to when analysing gross margin is what the frictional gross margin looks like.
That is, for every additional unit sold, what are the incremental costs and revenues of making that sale.
Usually, an incremental sale is highly profitable.
In most companies, overheads remain pretty much the same when you produce one extra unit of product (at least up to a threshold where you need to build a new factory or take another floor in an office building to accommodate all the extra people you’re hiring).
So the incremental costs tend to be low.
When I worked in the printing industry, our incremental costs were the extra sheets of paper we printed onto, plus a small amount of ink.
We were already paying for the printers, the machinery, the warehousing, and all the other costs of production. They didn’t change when we printed one more unit.
I find it’s not uncommon for businesses which might make a 5-10% bottom-line profit to have 70-90% margins on each incremental unit produced.
That being the case, the company’s perceived problem of a lack of bottom-line profits…which was translated into a “we need more sales” mantra…and became a “cash terms gross margin” issue…often morphs into a “how effectively we use productive capacity” problem. Often that’s the real root cause of a company’s bottom line problems.
And by productive capacity here, I’m not just talking about factories with machinery – I’m also talking about the fact that a lawyer, say, only has so many hours in a day to dispense advice they can charge clients for.
Are you charging enough?
Once you understand how that all works, your next thought should generally be “am I charging enough?”
Next to the issue of managing productive capacity well, this is the second most common issue I used to come across on a regular basis,
I’ve been lucky enough to work for some great businesspeople who were smart, knowledgeable, and hardworking, but who, for whatever reason, found it hard to charge an amount which reflected the value their business really brought to its clients and customers.
There is usually no faster way to solve a gross margin problem than to put your prices up. All your other costs remain “as is” – you’re just getting 10%, 20% or more for each unit you currently produce, exactly the way you produce it now, and with no costs of transformation or disruption or training to fund either.
Now, there is an important point to bear in mind before you try this.
You have to understand the value your business brings to its customers, first and foremost.
And, ideally, you have to over-deliver on that value.
For example, if you charge £100 to deliver £100 of value, some people will pay that. But you’ll never get them to pay you £120 unless all your competitors go out of business.
More commonly, I found, companies were charging £100 to deliver £200, £500 or £1,000 of value.
In a situation like that, for a likeable, trustworthy, dependable supplier, not many people are going to refuse to pay £120 instead of £100.
Now there is an art to demonstrating the value you bring in such a way as to get that extra £20, and you might need to do a deal along the way to phase in your increased pricing, but it’s generally do-able, when presented in the right way, if you deliver enough value to your customers.
It’s not sales, it’s margin
I fully accept that, having started this article poo-poohing the idea that you might need more sales, it now looks like we’re now back to where we started, and agreeing that putting more sales through the revenue line of your business would solve your problems.
Except we’re not really putting more sales here, even though the revenue line on your P&L is where that extra £20 will show up.
What we’re really doing is delivering more gross margin.
Your original £100 sale, with a marginal cost of £80, say, has now turned into a sale of £120 with a marginal cost still at £80.
In a business that was losing £10 on the bottom line against a revenue line of £100, you’re now making a profit of £10 on a revenue line of £120.
I don’t know many people who wouldn’t consider that a victory.
And, bear in mind, they haven’t touched anything inside their business yet. All they’ve done is deliver more gross margin.
Which is the important thing here, let’s not forget.
On the other hand, if you were losing £10 on a revenue line of £100, and decided to offer customers a 20% discount in the hope that would increase your sales, the most likely outcome is that you would end up losing £30 against a revenue line of £80.
That, most definitely, is not a victory. And illustrates why just increasing sales isn’t the solution unless you deliver an increased gross margin, in cash terms, by doing do.
All your costs are paid in £s, remember, not %s. So how much cash gross margin you create is the question, not what percentage number do you get to boast about to your mates.
Don’t neglect overheads
Although we haven’t spoken about it much in this article, don’t neglect your overheads. If there’s cost there to be removed, then by all means remove it.
But until you know where you’re going with your pricing strategy and your gross margin strategy, unless there’s anything outrageous in there, you should probably hold off significant cuts.
There is one very good reason for this.
As a sweeping generalisation, organisations which expect higher prices need to deliver higher levels of service. Everything needs to be slicker, better managed, more problem-free, and so on.
That means you can’t just implement some ridiculous AI chatbot (none of which are remotely helpful) to provide customer service. In general, to sustain a higher price you need to over-index on the level of service you provide.
While that might sound counterintuitive, remember that top hotels employ someone decked out in a top hat and a frock coat to open your car door.
That isn’t because you don’t know how to open a car door yourself. It’s an extra touch that makes guests think “Wow, the service around here is really good – that’s well worth another £100 a night”. (All credit to the great Rory Sutherland‘s “doorman fallacy” here, one of the smartest observations on pricing I’ve ever read.)
This is why you have to work out what you’re doing with your gross margins before you take a look at your overheads. Otherwise you might take decisions you come to regret.
Take away the doorman, in this example, and ultimately you haven’t saved a tiny salary in the context of a luxury hotel’s cost base. You’ve lost £100, or more, per room per night for eternity.
Given a choice, the smart thing to do is to keep the doorman employed and just accept that your overheads will be a tiny bit higher than they would be without him – but also acknowledge that your revenues are 100s of times higher than they would be without him.
(If you find that a difficult business decision to make, you might have much bigger problems than just the state of your bottom line…)
It’s a trade-off
Every business decision is a trade-off. Rarely does “painting by numbers” work. Certainly not in anything other than the short-term.
While I applied a consistent framework to get to the heart of what the issues were in my clients’ businesses, I can assure you there isn’t a one-size-fits-all solution here. Every solution for every client was different because the context of each client was different.
Anyone who thinks finance is just a matter of running up a few scenarios in a spreadsheet doesn’t understand what lies at the heart of good financial decision-making.
What always lies at the heart of a good financial decision is always a trade-off.
More cost today in return for less cost tomorrow?
Higher sales revenues, but with a higher fixed cost base to cover as a consequence?
Highly variable cost base, through using consultants and freelancers, but with the downside that they can all down tools tomorrow and go and work for your number one competitor, knackering your business in the process?
None of these decisions are objectively always right or always wrong. You have to understand the context to make the right decision.
And the context you need to understand more than anything else is how your gross margin really works, and what levers you can deploy to bring in more cash gross margin than you do today.
To find the best solution for your business, you have to dig more deeply than just demanding “more sales”.
Sales to the wrong sort of customer, or sales which don’t carry enough cash gross margin to cover your overheads, or sales that are made to hit a sales target without any thought of achieving a profit target, will take your business backwards, not forwards.
Those sorts of sales reduce your bottom line. They won’t increase it. No matter what some people will tell you.
The answer isn’t always “more sales”. But it is always “more gross margin”.
To work out how to do that, though, you need to dig deeper than most organisations do when they’re up against it and are frantically trying to cobble together some strategies to repair a big hole in their bottom line performance.
The good news is, having helped dozens of people fix a range of bottom-line problems, I’ve found that digging deeper is the only way they solve their bottom line problems for good.
It’s always worth the effort.