P1M5 Your Profit Drivers

So far we have seen two models of profit.

The cost volume profit or break even model with its focus on contribution rates, sales volumes and fixed costs and…

The four ways to profit model with its focus on the number of customers, the number of times they buy, the average contribution rate and fixed costs

Now we will make this more relevant to you.

Why Build Your Business Model

We need to move from the general idea of “this is how to make a business more profitable” to …this is how to make your business more profitable.

By establishing the main drivers of your performance, you can identify the key numbers you need to be monitoring so you can see when and how the business is improving.

But your specific model depends on your business, its type of business and the particular ways you want to grow.

The four ways to profit model provides a framework.

The number of customers is important – how you attract leads and convert them into customers.

You may find some lead generation techniques look much better than others but when you dig deeper and analyse, you find conversion rates are poor and the customers are low spenders.

How long you keep a customer and the number of times they buy are both important. The concepts are related but worth thinking about separately.

You may keep an average customer for 6 months and they buy once per month but think how it would improve your business if…

You could keep a customer for 12 months instead of 6

And they bought every two weeks instead of every month

That potentially quadruples the number of times a customer buys.

Transaction values …and especially the contribution on those transactions is vital.

When you understand how much can be gained from an improvement idea, you are motivated to try it.

When your performance measures report the new improvement is working, you are motivated to make sure it carries on.

I hear things like:

“We used to do that and it seemed to work well but we stopped. I don’t know why…I guess we got distracted by something else.”

And when you see that a proven technique stops working, you have a chance to improve it.

I have prepared a little spreadsheet as an example to give you a few ideas.

Business_model

I was going to protect all the formulas and then decided if things went wrong, you could just come back and download it again. Just change the values highlighted in pale Yellow.

I have given you two columns so you can try changes on their own to see the effect and then add them into the multiple change model. (This should probably be one of my first videos)

I’ve not put all the complicated links in because a complex spreadsheet designed by someone else is very difficult to understand.

It’s important that you don’t try to make it too complicated.

I don’t want you to see it as a one off exercise either…it’s the kind of thing you should keep trying to refine as you become more confident in measuring and managing for profit.

Financial Years vs Customer Relationships

I want you to make more money and I don’t want you to fall into the traps.

Thinking in financial years is in many ways an artificial concept.

It’s necessary for reporting purposes if you are managing someone else’s money and of course it’s necessary for tax purposes.

But the financial periods idea is abused by many big companies who are always under pressure to make the next quarter’s results and hoping the long term takes care of itself.

The focus is on managing the short term.

Getting £10,000 profit from a customer this quarter and nothing else may be better than getting £6,000 this quarter and £8000 next quarter if it means targets get hit for bonuses.

Unless you are in a crisis situation or getting ready to sell out, that type of thinking doesn’t make sense for an owner-managed business.

You want the maximum stream of profits and for tax reasons may even want to defer profits from the end of one year into the beginning of the next.

If your business is in a crisis and you are not sure there is going to be a next quarter, it is different.

Your task is to do whatever has to be done to make sure there is a next quarter – spending time and money on the future is a waste when all that matters is NOW.

Since profit comes from customers, it is important to think long term

In fact you should be thinking about how to maximise the lifetime values of customers.

Lifetime Value of Customers

The lifetime value of customers, the customer lifetime value or the marginal net worth are similar concepts.

It’s basically saying how much is a customer worth to the business over the length of the relationship and of course, you should be thinking profit/contribution rather than sales values.

Read: Lifetime Value Of Customers and Calculating The Lifetime Value

Past Transactions Future Prospects

Profit is what is known as a lagging indicator.

It reflects the profit on the sales you have made in the past.

Some businesses will receive an order today and despatch today or tomorrow. Their profit figures accurately reflect their current performance.

Other businesses have much longer sales cycles.

I worked with several capital equipment manufacturers who could take 18 months to specify and negotiate the order… another 12 months to deliver the equipment…and six months to get it fully commissioned and approved.

In that type of business you have three areas to focus on…

  • The profit on sales made
  • The profit on orders received but not yet sold
  • And the potential profit on the prospective orders being negotiated.

Where there is a long sales cycle, it can be very useful to monitor the sales pipeline.

That’s an estimate of the future sales and profits of leads received based on the stage and probability of success.

It puts a number on the sales activity at the time it is happening and shows if there are potential problems lying ahead.

Building Your Model

Start simple.

Make sure you understand the big drivers of your profit and you have measures in place for what really matters.

You may have 20 ways to attract customers but only three that give you big numbers. Track those three and have a catch-all others category for the rest.

The more you understand the dynamics of your business, the more you can make sure they work to your advantage.

For example a health club may only have 40% renewals after the first year so it may be better finding ways to increase the retention rate than finding new ways to drive in customers. Otherwise there is a growing number of people who tried it and didn’t like it to stay as members.

My main message is that you shouldn’t live in hope of making profit but work out how you can make money.

From Model To Monitor

When you’ve identified what drives your performance and future profit, you will want to monitor what is happening.

Your Business Model will therefore form the basis for your Performance Monitoring report.

You may want to track measures in different ways:

  • daily
  • weekly
  • monthly
  • quarterly or
  • on a rolling 12 month / moving annual basis – that means from July last year to June this year and then August last year to July this year.

How often you track will depend on:

  • how important the number is
  • what it tells you and
  • whether it will lead to action.

Sometimes just being measured and having the feedback and control can lead to improved performance.

When something is measured and reported, it sends out a clear message “This is important”.

But you need to find a balance between the value of knowing versus the time and cost of reporting.

One of my clients had the lovely expression “They spend so long weighing the pig…they don’t leave time to fatten it for market.”

Building Your Performance Monitor

Here are some tips about putting together your performance monitoring report.

First you should look to balance past, present and future – find your balance between sales, outstanding orders and the sales pipeline.

Second, it is very useful to have comparisons since performance numbers on their own may not mean much. Common examples include last year and budget (or forecast or target).

I like to use a combination of trend performance from the recent past to show if things are getting better or worse and performance against targets to show if things are getting better as fast as we wanted or needed.

I prefer contribution information to sales values but they are more difficult to get so use what you can and understand the limitations of the information.

I recommend you monitor your customers who are not buying…perhaps track the cancellations each month or if customers usually buy every two months track those who haven’t bought for three months.

You should also pick up the key cost drivers  – that might be the number of employees, the number of hours worked, overtime premiums paid, scrap rates, productivity statistics.

Your monitor will be unique to you.

Even in the same industry with the same drivers of performance, your monitoring system should reflect your strategy – the things important to you.

Reporting Numbers So They Can Be Understood

The value of performance measurement comes from you:

  • Knowing what’s going on and being in control
  • Taking action when necessary

Your numbers need to be telling you something.

In effect they need to pass the “So what?” test.

When you report numbers, people generally struggle to understand anything long – it becomes a confusing jumble.

3 significant digits conveys the broad picture together with a sufficiently detailed number.

If your year’s total sales are £1,262, 584.56 then £1.26 million is good enough and so much easier to understand.

If you are clever in Excel or do it manually, a traffic light system based on targets can be good – Green means fine, amber is a warning and red is a problem. It does attract attention.

Graphs can make it much easier to see trends and especially if there are ups and downs in an overall rising or declining trend.

But detail can be lost in graphs or become overly alarmist depending on what you do with the y vertical axis settings.

Finally you may want to reverse some measures to have more impact – a happy customers rating of 95.3% sounds good or even brilliant because we are conditioned to percentages from school days.

4.7% or even the number of unhappy customers can help to focus the mind.

What To Do

Put together your first business model based on the Four Ways To Increase Profit and then see how your results can change as the underlying drivers change.

Then start putting together your Performance Monitor.

Think what you’d like to have and then what you can practically get.

It won’t be perfect and if there are a few gaps, then that’s OK.

The important thing is to start monitoring your business performance in a way that is consistent with your profit drivers. You need to see what’s happening so that if there are any problems, you can get it fixed quickly.

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