Home Builder Nevada

Manage Customers and Product Lines to Improve Profitability

Am I building a business worth buying?

by Mike Rudd

Eighty percent of a company's revenue comes from 20 percent of its customers. It is also true that 80 percent of a company's profit is generated by 20 percent of the customers. What is surprising, however, is that these are not often the same customers.

Sometimes, the biggest customers are the most demanding. They tend to place an inordinate amount of strain on the company infrastructure (i.e. delivery, inventory stocking levels, pricing, payment terms and handholding), which reduces gross margins. On the other hand, the customers who place their orders on time, expect a reasonable delivery schedule and pay a fair price (on time) generally produce a higher gross margin. All things being equal, these customers' transactions will produce an appropriate profit for the business and reduce stress for employees.

Identify Profitable Customers

Determining who the best customers are requires some analysis to separate perception from reality. This analysis includes identifying a minimum gross profit acceptable for the business to achieve a return on the risk of doing business. A customer that habitually pays in 60+ days is inherently less profitable than one that pays in less than 30 days. This "cash conversion cycle" is the time frame from the initial order placement to the receipt of funds available to the business. A shorter "cash conversion cycle," reduces borrowing and interest expenses. The result is a more profitable customer.

Credit worthiness is another key profitability factor. With a company gross margin of 30 percent, when a customer fails to pay a $25,000,00 balance, an additional $83,333.00 needs to be sold just to make up for the loss, It is imperative to maintain and enforce strict credit policies. For example, when a customer that has not done any business with the company suddenly places a large order, there is cause for additional investigation. It is important to determine if the new customer is on credit hold where they regularly do business, or if they are at their credit limit and are seeking new credit with this new transaction.

Beware of a customer who demands special treatment due to their inability to plan effectively. They can create a cascading effect that forces adjustment in schedules, rushed orders and impacts the ability of the company to service other customers. When product and delivery promises are broken, existing profitable customers become dissatisfied. This possible scenario could send them to another supplier.

Sales Incentives

Incentives for the sales team can produce profitable sales, not just sales for sales sake. The most effective way to hold a team accountable to produce profitable sales and motivate the sales team is to develop a program that rewards and pays a higher commission based on gross profit, The higher the gross profit, the higher the commission. Conversely, sales that do not meet margin requirements are paid less commission or if the margin is too low, the sale is refused or no commission is paid.

When commissions are not linked to gross margin, sales can increase but the company "grows" itself out of business due to increased overhead to support the revenue. In this case, the margins do not support the increased expense. This same "profit based incentive" philosophy should be used for all employees. Incentives must be tied to areas the employee has control over such as labor hours, overtime, material costs, inventory waste and consumable supplies. This is in direct contrast to what is known as an "entitlement" bonus that is not tied to any quantifiable performance standard.

Information Central

Develop a system for accurately tracking and managing financial information on a daily, weekly, monthly and annual schedule. In most companies there is a lack of truly useful information that enables the business owner to make sound, informed decisions. Without accurate information based on historical percentages, it is impossible to measure the impact on break-even rates by product line, overhead applications, inventory levels and pricing matrixes. The chart of accounts developed for a tax based accounting system, for example, fails to accurately provide information that can identify what is really going on in the business. The correct chart of accounts should have a primary focus that categorizes what information is critical to the effective management of the business.

It is also important to recognize the variables associated with each business activity that fall outside of predetermined performance standards. Relying on "gut" feelings or annual financial statements that are three to four months behind can lead to misinformation and sometimes provide a false sense of security. Rather, create a matrix of financial and production information to identify the profit peaks and profit drains. Then take decisive action to capitalize on high profits and eliminate the company's financial risks.

Improving profitability starts with a substantial effort to understand all facets of the business enterprise. This requires using tools to measure the product lines from a profitability perspective. Possessing this information on a current basis enables the company to react to the ever-changing business climate as quickly as required by the marketplace.

Working Capital and Cash Flow

Most businesses start with inadequate working capital and never reach the point where there is sufficient capital to manage the daily and weekly cash requirements and grow the business profitability. That's why it's important to realistically identify the business needs and maintain an adequate safety net to compensate for the unexpected. Predicting and improving cash flow are functions of clearly understanding the revenue, margin and expense cycles of the business.

Estimating future cash requirements is also a key component of any business plan. Often called a budget or a pro-forma financial statement, the numerical analysis provides a working model of what is anticipated. In this way, for example, the company can determine the cash needed for manufacturing or purchasing the products. Once products are in stock, the estimate can identify how long it will take to turn the inventory, into revenue. This provides the basis for knowing how much cash is needed. If the amount of cash required is greater than the amount of cash available, the business will either have to borrow or choose a whole different product and manufacturing cycle.

From Technical Expert to Strategic Business Owner

Managing customers and managing product lines require business owners to work "on" the business as opposed to work "in" the business. The transition from technical expert begins with a paradigm shift from an operational focus to a strategic one. It involves making sound decisions based on current and accurate information and well-established systems, methodologies and procedures.

A competent business owner treats the business as if it is for sale - everyday. Every decision must be evaluated by answering the question, "Will taking this action enhance shareholder value in the company?" And, at the end of each day, another question to answer is, "Am I building a business worth buying?" "Yes" is the only acceptable answer to these questions.