Essential skills for accountants: What drives profit

value pricing Oct 23, 2017

What are the drivers of profit?

 
We can add more value to our clients by helping them increase their profits. However, we need to understand that profit is the end result of numerous other drivers. You can’t help a client improve their profit. However, you can help them to improve the underlying drivers.

 
As you know, profit is made up of total annual sales minus expenses. However, there are different types of costs in a business that behave differently. The main two, as you know, are variable costs (sometimes called direct costs) and fixed costs. When we do a set of annual financial statements, we normally show sales minus direct costs, which is the gross profit, minus fixed costs, which is the profit. The trouble is, we're just scratching the surface because we need to understand what drives those things.

 
You can find the full video explaining these powerful drivers, as well as 3 other videos, when you sign up for my free video course here.

 
Increasing customers is helpful…

 
Let’s look at two examples of profit drivers. Firstly, the more customers you have, the more the sales go up - customer numbers are a driver of profit. Another driver is price. When we change price, that changes the sales revenue, which in turn changes profit.

 
Now, imagine a typical business turning over 1,000,000. Let's imagine that direct costs are 50%, so their gross profit margin is 500,000. And fixed costs are 400,000, giving a bottom line profit of 100,000.

 
Firstly, lets look at what happens when you increase the number of customers. This is largely a function of marketing. If we can improve the number of customers 10%, then we could help the client to grow and improve their profits as a consequence. There's nothing wrong with doing that. That's where most consultants would start.

 
Here’s what would happen. New sales will become 1,100,000, a 10% increase. If we've got more customers and we're doing more volume, then our direct costs will also grow by 10%, becoming 550,000. Our fixed costs are 400,000 and therefore our net profit increases to 150,000.

 
Of course, whilst that's mathematically correct, we also have to bear in mind that to do that we're going to have to do some marketing activities, such as investing in advertising. We should really account for the cost of doing that, and so our fixed cost is likely to go up as well. Consequently, the impact on net profit is unlikely to be as big as we'd hoped. It might go from 100,000 to 125,000, for example.

 
…But increasing price works better

 
Now lets imagine that rather than focusing on winning new customers, we help our client with their pricing and help them to increase their average price by 10%.

 
Because it's a price increase, it has no impact on their cost structure. Total sales go up from 1,000,000 to 1,100,000. The costs won't change, they’re still 500,000. The fixed cost is still 400,000. The bottom line profit is now 200,000. We have doubled our bottom line profit from a 10% increase in price.

 
Of course, what I often hear is, "Yes, Mark, but if we increase our price by 10%, we might lose customers." We might. However, the reality is most businesses lose a lot less than they think. I've been teaching accounting firms how to move to value pricing for the last 17 years, and I’ve heard story after story of firms who have followed my advice and increased their prices by sometimes 20% and have hardly lost any clients as a result.

 
We lose less than we think, but let's assume for a minute that we help the client put their prices up by 10% and the client loses 10% of its customers. If that happens, then we find that sales works out at 990,000. With 10% less customers direct costs now reduce to just 450,000, so our bottom line profit will be 140,000. Still much better than if we'd gone with increasing the number of customers.

 
When you can share with your clients techniques for increasing their prices in a way that makes a big difference to their profit, you become the hero. Their loyalty will grow and, most importantly, you could start to charge premium prices, particularly if you launch a full-blown consulting service.

 
To find out more about this powerful topic, and to help you start your price consulting journey, sign up for my free video course here.

 
Wishing you every success on your pricing journey.

 
Mark Wickersham
Chartered Accountant, public speaker and #1 best-selling author of
Effective Pricing for Accountants

"A Practical Approach To Value Pricing"

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