Fundamentals of Business

Ways to improve profitability

Ways to improve profitability there are four factors that affect profitability: Equation Profit = Revenue - (Variable costs + Fixed (capacity) costs).

Costs
Cost reduction is easier to achieve than price rise, it better to approach profit from costs perspective. Costs are predictable hence easier to control, an appropriate way to improve profit margins is to cut costs rather than to increase price. A cost reduction in areas of purchasing, production, selling & distribution, administration and research and development could significantly reduce costs and produce corresponding increase in profit. For example

An extract from Wall Street Journal
Bristol Myers Squibb Co. is the latest big pharmaceutical company to announce a restructuring in the face of looming generic competition and pipelines with few potential blockbusters. The New York drug maker said it will cut its work force by 10%, or about 4,300 jobs, and close or sell about half of its 27 manufacturing plants in a plan to save about $1.5 billion by 2010 and boost profitability.

Price
If price is raised while costs remain constant or costs rise less than price increase, profit margin is increased. Caution: it can be tricky to convince customers to pay more as they may look for substitutes elsewhere. You must not confuse the price rise to cover for inflation from price rise to boost profits.

Sales volume
generating a higher sales turnover from the same value of assets.

Reduce capital employed
It may be possible to reduce capital employed. If sales are maintained from a smaller value of capital employed, then the more efficient utilisation of assets raises the asset turnover figure and directly contributes to a high profit percentage.

Controlling working capital
Time is the common feature of all items making up working capital. The longer the stocks and or in progress are held and debtors remain outstanding, the more capital needs to be found to finance them.

An effective working capital control should concentrate on minimising the time stocks are held, work in progress processed, debtors pay up, but on the other hand extending the time which creditors are paid. Management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ).

Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa );

Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring" or "invoice discounting".