Thursday, July 5, 2012

9 Key Performance Indicators for Building An Effective Profit Plan (Part 2)

Last month we covered the 9 specific performance indicators that you need to consider in building a profit plan for the new financial year.

This month, we'll examine how you build a profit plan, utilising those indicators.

I'll go through two simple approaches - one based on targeting a desired profit level and the second aimed at devising a profit plan based on what you might consider an achievable sales target. The second approach may be one that you may wish to consider in a changing market where sales may be reasonably expected to drop. Of course, this second approach may be considered a little defeatist and would only be considered if a full strategic analysis of the business determined that there was no scope to increase or maintain sales in the environment the business operates in - this is unlikely!

Approach 1

Let's say that your business profitability in the previous financial year looked something like this:

Sales                                                      $1500000
Less Cost of Sales                                    975000
Gross Profit                                              525000
Gross Profit Margin                                      35%
Less Overheads                                       250000
Net Profit                                                  275000

Number of Sales                                       60000
Av. $ Sale                                                          25
Number of Opportunities                       80000
Conversion Rate                                           75%             

Note: Refer to Part 1 of this article for definitions of the above terms.
            Gross Profit Margin = Gross Profit/Sales
            All figures GST exclusive

Now, say you wish to target a profit of $350000. You believe this be feasible within your existing cost structure. You also believe that your gross margin will fall to 34% (for a more detailed discussion on strategies for managing your gross profit, refer to my previous blog post "Maximising Your Gross Profit")

Your target sales will now look like this:

Overheads                                          $ 250000
Target Profit                                          350000
Target Gross Profit                               600000
Target Sales @ 34% GPM                  1764705 ($600000/34%)

So, you need to find an extra $264705 in sales. Now, discounting in order to boost sales generally fails, unless you have lower costs that your competitors or are able to cut your costs. According to Reed Holden of Holden Advisors, US based pricing specialists, you need to innovate for growth.
So let's look at what you could do:

1.       Improve effectiveness of your marketing, to increase the number of opportunities (or store traffic). If you were able to increase the number of opportunities by, say 1%, there would be 800 more opportunities. If 75% were converted in sales, there would be 600 extra sales at $25 = $15000 extra sales

2.       If you were able to improve your merchandising and customer service and increase the  conversion rate on sales to 80%, together with the increased opportunities in 1) above, there would be 80800 opportunities converted at 80% at $25 per sale = Sales of $1616000 - an extra $116000 in sales

3.       If you were able to improve your merchandising, product range, customer experience and sales systems so that you were able to increase your average $ sale (by add on sales and/or up selling) to $27.30, your sales would be 80800 opportunities, converted at 80% at $27.30 per sale = $1764672 - your targeted sales level!

Put simply, a 1% increase in the number of opportunities, a 5% increase in your conversion rate and 9% increase in your average sale has produced the required increase in sales and a $75000 or 27% increase in profit! Of course you can explore variations in each of the 3 factors above to work out your profit plan. You could also consider increasing your prices! The challenge is, of course, to develop and implement strategies aimed at improving each area - much easier said than done. Which is why some businesses do much better than others - they are continually working on their business, building strategies, testing them and implementing those that are successful - then starting the whole process again!

Approach 2

Let's say that you have undertaken strategic planning and as a result, you believe that sales next year look to be around $1600000. The gross profit margin (GPM) predicted is around 34.5%. You wish to target a profit  of $290000. To achieve the desired profit, what must you budget your expenses to be?

This is calculated as follows:

Sales                                                      $1600000
Less Cost of Sales                                  1048000
Gross Profit @ 34.5% GPM                   552000
Less Target Profit                                    290000
Target Expenses                                      262000

You would then closely review all expenses and assess each on their effectiveness in delivering value in accordance with your business model. Be very careful as costs can be cut that much that you deliver insufficient value to your customer - as a result, you don't deliver the required number of customer opportunities, don't convert them at the required rate and/or don't sell at the required av. $ value to achieve your target sales.

My preference is to work under Approach 1 as it is a much more positive approach which can lead to the development of innovative initiatives that can take your business to a new level.

I wish you the best in your development of your financial plan for the new year. I am happy to answer any questions that you may have - you are welcome to email me at the following address:


Chris Smith said...

Nice Blog and great post your post is very helpful for me and others.
accountancy services uk

Chris Foster said...

Hi Chris
Thanks for your kind feedback