Most business owners rely on common financial ratios in order to calculate their company’s profitability, such as gross profit margin, operating profit margin, net profit, cash flow, and ROI. The ratios follow standard formulas and can be relatively easy to calculate—provided you have the right numbers.
One common problem, however, particularly in fast-growing businesses, is that the company executives may not necessarily agree on exactly which numbers to use and how they will go into the calculations.
This is where major issues begin. While methods of calculating profitability can vary from company to company based on business models and needs, everyone within your company needs to be on the same page. That means that profitability calculations need to be consistent across departments, and they need to be fully transparent and understood by all stakeholders.
When different teams make different financial assumptions for their calculations, or when they only see a portion of the entire financial picture, this can cause serious hiccups not only in your day-to-day operations, but also your long-term strategy and planning.
Short-term miscalculations: Working off incomplete assumptions
Let’s take for example a retailer with an ambitious $10 million sales forecast for the upcoming holiday season. The sales manager develops a purchasing plan, basing it on last year’s holiday revenue numbers and profit margins. The plan is approved and the purchase orders are sent out.
But say the manager only sees the sales numbers from her department, and isn't privy to the rest of the company's finances. Though her purchase plan is formed on numbers fitting to her department, it doesn't take into account the additional company expenses incurred for a new location opening for the summer. Suddenly, the company doesn't have enough cash to pay for its holiday inventory order!
This is a classic revenue vs. cash flow calculation mistake. Revenue isn’t calculated in the same way as cash, and this can trip up a lot of companies as they try to scale their business. Planned cash expenditures need to be carefully planned and tracked throughout the year as part of the budgeting process, and these need to be communicated across all team or departmental leaders.
Another common mistake is failing to factor in fixed costs when calculating pricing. Accounting for overhead should be a major consideration in determining the pricing of individual products and services. For companies with multiple product lines, business owners may want to consider separating general shared overhead with product-specific overhead, such as special production equipment or employees dedicated to that product line.
Many of these issues can be solved by using your finance team as a gatekeeper. As the team with the most comprehensive picture of the business, they can advise and vet purchasing plans, budgets, pricing, and other profitability calculations, so that your business doesn't run into cash flow issues.
Long-term missteps: Not understanding your “Profit per X”
There are a number of ways you can dissect financial data and calculate profitability, but always looking at multiple financial metrics can often take away from the larger goal.
Take for example a manufacturing company with two key product lines, Product A and Product B. The product manager performs a simple gross profit margin calculation and sees that Product A has brought in higher revenue at a higher profit margin. His recommendation is to invest in better equipment to produce more of Product A.
But the sales manager has different ideas. Product B has a far shorter sales cycle, selling at 3x the volume and 60 days quicker than Product A. She would like to scale the sales team to sell Product B in an expanded sales region.
Which direction should the company go? It depends on what the company wants to take as its “Profit per X.” Termed by author Jim Collins, this ratio challenges businesses to decide on one standard metric that will serve as the company’s critical economic indicator. As Collins says, “If you could pick one and only one ratio—profit per x—to systematically increase over time, what x would have the greatest and most sustainable impact on your economic engine?”
Companies that think strategically about and stay committed to their metric often end up outperforming their competitors. Collins featured Walgreens as an example. The industry standard metric of profit per store ran contradictory to Walgreen’s key value of convenience. By focusing on per store profit, Walgreens couldn’t justify putting stores close together or in expensive locations. But when they switched their focus to profit per customer visit, they were able to focus on getting customers to buy more and buy more frequently, thereby increasing profitability across their entire system.
There are many considerations to choosing the right “x” factor, but using this metric ultimately helps to drive long-term growth. Are you focused on profit per customer? You’ll want to focus on getting returning customers to buy more products or higher-priced products. Focused on profit per product sale? Then you’ll want to shift your focus to operational efficiency and reducing costs.
Getting everyone on the same page
To ensure that profitability miscalculations don’t end up as a roadblock to your company’s growth, it’s important to get everyone on the same page when it comes to overall financial strategy. Here are some of our tips we recommend to clients:
The best finance teams are not just used for operational processes, but also as a strategic business tool. They should be able to provide helpful insights into your company’s profitability and ensure that your financial plans don't run into any issues throughout the year. They'll also be able to help with long-term strategy and growth, advising the company on which areas of the business to focus on and optimize.
Make sure everyone is operating off the same numbers and assumptions. When data isn’t consistent across various company platforms, you’ll inevitably end up with mismatched calculations. Don’t allow team members to create their own assumptions—from your "profit per x" to how you allocate overhead expenses across teams, the key assumptions must come down from the top.
Good communication ensures everyone stays consistent. Team managers should make a habit of regularly reporting on KPIs. This helps to keep things transparent and focused, and allows companies to catch financial mistakes before they become major issues.