Profit and Cash Flow Don't Necessarily Go Hand In Hand

PROFIT AND CASH FLOW DON'T NECESSARILY GO HAND IN HAND

There are business fundamentals that are common to each and every business - and at the heart of every situation is the importance of profitability and cash flow. It is vital to understand the difference between them and that profitability and good cash flow do not necessarily go together.

Profitable businesses can go out of business because of cash flow problems.

So what is profit and what is cash flow?

"Profit" is what's left over after you've paid all your expenses. This is nothing you didn't know before. The important thing to note is that profit is "what's left over". PROFIT IS A RESIDUAL. It is a consequence of what happens in and to your business. Some of these things are within your control and some of them are outside your control. If you're going to have any effect on your profit, you have to focus on those things over which you have control.

So what are they?

To answer this question, it is helpful to understand that there are only four specific factors that determine profit. These are:

1. the PRICE you charge for the products and/or services you sell.

2. the QUANTITY (or volume) of products or services you sell.

3. the costs you incur directly in producing or buying the products and services you sell. We call these VARIABLE COSTS because they increase or decrease as your sales increase or decrease.

4. the costs you incur whether you make any sales or not. These are called FIXED COSTS because they don't change with changes in sales volume, at least not on a day-to-day basis.

Let's use an example to put these four factors together.

Suppose you sell a product called a widget. It costs you $60 which is the variable cost and you sell it for $100 (this is the price).

If you sell 100 widgets (the quantity) the variable costs will be $6,000 and if you sell 50 widgets the variable cost is only $3,000. It varies directly with your sales volume (or quantity).

Now, if you sell a widget for $100 and it costs you $60, then you've made a profit of $40 on each sale. This is the gross profit or gross margin.

But you still have to pay your fixed costs to end up with your net profit.

If your fixed costs for expense items such as rent, leases, insurances etc are $3,000 and you sell 100 widgets and make a gross margin of $40 on each one, then your total gross margin is $4,000 and after deducing your fixed costs of $3,000, you will end up with a "net profit" of $1,000. The "net profit" of $1,000 is "what's left over" after deducting the variable costs of $6,000 and the fixed costs of $3,000 from your total sales of $10,000.

On the other hand, if your fixed costs are more than $4,000, then you'll incur a loss.

We can restate these factors in the traditional Profit and Loss Statement format:

SALES (Quantity X Price) $10,000

100 widgets at $100 sale price each

Less

COST OF SALES (Variable Costs) 6,000

100 widgets at $60 cost each

Gross Profit 4,000

100 widgets at $40 gross margin each

Less

FIXED COSTS (Rent, leases, wages, insurances, etc.) 3,000

NET PROFIT (what's left over) $1,000

The Net Profit is the Resultant Figure from the Sales less Variable Costs less Fixed Costs..... and we have some control at least over each of these items.

Profit can be affected by focusing on those things over which you have control.

Any profit improvement strategy must focus on either or both of two things:

1. achieving a higher gross margin per dollar of sales by increasing price and/or reducing variable costs

and/or

2. achieving greater sales per dollar of fixed costs by increasing the sales volume and/or reducing fixed costs.

So that we can put everything into perspective, let's consider the profit improvement potential that would arise from a modest improvement in each of the four factors. We'll use the previous example as a base and assume a 5% improvement in each of the four factors.

BASE CHANGE/ RESULT

IMPROVEMENT

Price $100 5% increase $105

Sales Vol. - units 100 5% increase 105

SALES $10,000 $11,025

Less:

VARIABLE COSTS $6,000 5% decrease $5,985

($60 each) ($57 each)

Gross Profit $4,000 $5,040

Less:

FIXED COSTS $3,000 5% decrease $2,850

NET PROFIT $1,000 $2,190

It is evident that a relatively small % change in each of the four factors has a staggering effect on the resultant profit.

In the above example, a modest 5% improvement in each factor without a consequential unfavourable impact on each of the other three would more than double your profit from $1,000 to $2,190.

This is a 119% improvement in profit and from only a 5% improvement in each of the factors that affect profit.

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