Why business is like a wheel and how to avoid having a wonky one!
Business as a wheel
I see business as a wheel. Your gross profit is the core of the wheel. The spokes are your fixed costs, the tax due on your profit and how much you need to take out. The tyre is your customer base. If the core is not strong enough, you can only afford a few spokes and you end up with a wonky wheel and that's not a comfy ride for anyone. If it stays wonky, your business will not survive.
As your business grows, your tyre (customer base) gets thicker. To support that growth, you need more spokes (increase costs). To pay for the increased number of spokes, your core must strengthen too (increase gross profit). If you don't make enough money to support your growth, your business will not survive.
On Black Friday, huge discounts are offered in an attempt to increase sales before Christmas. I will be sharing how sales discounts impact on how much net profit you make.
Also, as the New Year approaches, you may be thinking about growing your business in 2019. With this growth, you may decide to commit to new staff, new marketing strategies or new premises. I will be showing you how increasing your fixed costs, without increasing sales targets by the right amount, impacts on your net profit.
The reality of business survival in the UK
According to the National Office of Statistics, business births and deaths in 2016 were:
Up from 383,000 to 414,000 = 31,000 more business births
As a percentage it is up from 14.3% to 14.6% = 0.3% increase
Up from 283,000 to 328,000 = 45,000 more business deaths
As a percentage it is up from 10.5% to 11.6% = 1.1% increase
Also, the UK five-year survival rate for businesses born in 2011 and still active in 2016 was 44.1%.
Here is a table showing the survival rates from year 1 through to year 5:
Common reasons given as to why businesses fail
Six common reasons offered for why businesses fail are:
- Leadership failure
- Lack of uniqueness and value offering
- Not being in touch with customer’s needs
- Unprofitable business model
- Poor financial management
- Rapid growth and over expansion
It can feel relatively easy to get help with numbers 1 to 3 but 4, 5 and 6 can appear to be much trickier to tackle, as it’s all around the numbers and how a decision in one area, impacts on the others.
The three key profits in your business
It is imperative that you know these three key profit figures in your business and how a change in one, impacts on the others.
The formula is:
Often business owners think of giving a discount as a great way to increase sales. However, if the discount doesn't generate enough extra sales, you may be left with less net profit than if you didn't give a discount in the first place!
Here is a table showing three scenarios that show you the impact on net profit if a 10% discount is given.
Scenario 1 - This is the starting point, where no discount is given and the desired net profit of £3,240 is achieved.
Scenario 2 - No change in sales achieved but a 10% discount is given. This generates £810 (£3,240 - 2,430) less net profit. That's 25% less net profit!
Scenario 3 - To generate the same desired net profit of £3,240 and give a 10% discount, sales will need to increase by £1,667 (£11,667 - £10,000). That's 17% more sales!
What happens to your net profit if you increase your fixed costs?
When taking on a new fixed cost, whether it’s a member of staff, a new marketing commitment or new premises, it is easy to think about it as the extra cash needed only.
Here is a table showing three scenarios that show you the impact on net profit if Fixed Costs are increased by £2,000. In this case, a new member of staff.
Scenario 1 - This is the starting point, where there is no additional commitment to Fixed Costs and the desired net profit of £3,240 is achieved.
Scenario 2 - No change in sales achieved but Fixed Costs is increased by £2,000. This generates £1,620 (£3,240 - 1,620) less net profit. That's 50% less net profit!
Scenario 3 - To generate the same desired net profit of £3,240 and increase Fixed Costs by £2,000, sales will need to increase by £2,857 (£12,857 - £10,000). That's 29% more sales!
The two examples above, help to highlight how important it is to work out the impact of a financial decision BEFORE you commit to it.
It is imperative to work out the sales you need to achieve, in order to make a viable business decision that ensures you don't end up with less net profit than you need.
Less net profit means less money available to you personally. If you aren't making enough money, you may decide to 'borrow' from the tax pot, delay paying your creditors or take out a company loan to fill the gap. Your business will definitely feel like a wonky wheel!
It is my belief that businesses fail because they fail to work out achievable sales targets that leave them with the net profit they need.
The Revenue Target Calculator (RTC) on the SAS Business Box works this out for you. You tell it what you want to be left with, it tells you how much you need to sell. It's a simple five step process with no complicated spreadsheets. Why not try it for yourself and avoid having a wonky wheel!<