There are number of ways to look at profit and how to go about managing profits and margins in the kitchen and bath industry. Some of the terms associated with profit are net profit, gross profit, cost of sales, overhead and profit margin. Every time a business decision is made, it will have a specific impact on some or all of these. In most cases the primary issue comes down to the bottom line, or net profit.
We will begin by defining gross and net profit and how these are determined. We will also examine how to view each of these concepts over the long term, as well as the short term. And finally, we will look at marginal cost/profit analysis and how to use this effectively without falling into its inherent pitfalls.
From Revenue to Profit
It’s important not to confuse cash flow with profitability. While this seems obvious, it can be easy to ignore our accounting records if our business is awash in cash as a result of timing differences between receiving revenue and having to actually pay out the associated costs.
We mentioned the bottom line above, or more precisely, what is left after all costs and expenses are subtracted from the related revenues. For a business, the more complete and accurate definition is that net profit (or loss) is the difference between the business’ net worth at the beginning of a period and the end of that period (net worth being defined as total assets minus total liabilities). While this definition does provide the most accurate account of net results, it does not show how we got from point A to point B.
An income statement will show us this by breaking down revenues, cost of sales and expenses. The cost of sales is considered to be directly variable with revenues; that is, there is a direct relationship between revenues and the cost of producing those revenues. Cost of sales includes such items as materials, job labor, etc. and the difference between revenues and cost of sales is defined as gross profit.
Income statements should normally be produced on a monthly basis. In our business, cost of sales would also be broken down on a job by job basis with some form of job costing system, since that is the level at which we are trying to control such costs. The topic of job costing is beyond the scope of this article, so we will not delve into that at this time.
The other class of costs are those which are relatively fixed in nature and usually referred to as operating expenses or overhead. Our objective is to generate enough gross profit to cover all of our expenses and produce a net profit. Let’s look at a very simple example to illustrate our discussion:
Revenues $200,000
Cost of Sales 120,000
———–
Gross Profit 80,000
Overhead 70,000
———–
Net Profit $ 10,000
======
Assume that the example above represents one month’s revenue and expenses. It is likely that we could increase our sales revenue by $20,000 without having to increase our overhead. If our gross profit margin remained constant at 40%, this would produce an additional $8,000 net profit. Likewise, if your sales revenue fell $20,000, the net profit would fall by $8,000.
In the short run, monthly variances in revenues will likely have some slight impact on overhead such as utilities and office payroll. Revenues can vary up or down considerably without any significant change in such expenses. Over the longer term, increased sales activity will normally require an increase in such costs as additional staffing or overtime added to handle the increased administrative load.
We conclude from this that the term "fixed expenses" really refers to a short-term situation and all expenses are variable over the longer haul.
Marginal Cost
In Econ 101 we were taught that sellers will keep selling at lower and lower prices until the cost of producing that last sale equals the revenue it generates. Without getting lost in this discussion, we are faced with similar situations in our businesses.
Since we are in a business where each sale is for a distinct “bundle of products and services,” there is an element of negotiation involved and we must make an evaluation of what an acceptable gross profit percentage (margin) is. Further, since our revenues usually consist of a few large sales each month, we are in a position to view the impact of each additional sale on our business
If we assume that we have reached our normal monthly revenue of $200,000 and we have the opportunity to add one more $20,000 job if we are willing to take it on for 20% gross profit, it would make sense to do this. Since our overhead would likely only be slightly impacted, this would produce an additional net profit of almost $4,000.
The process of evaluating each transaction as it is added to total revenues to see if it results in more revenue than it costs to produce, is referred to as marginal cost analysis. In theory, we would keep adding jobs until the cost of adding the last job equaled the revenue it produced. This process would maximize our net profit. In reality, there is a trap hidden in this process.
Competitive pressures will come to bear on the situation and our taking jobs from our competitors at less than normal margins will probably cause them to respond by meeting our “marginal” pricing and thereby preventing us from doing our first $200,000 of business each month at the 40% margins we had enjoyed. Even without actual competitive pressure, we will tend to let the margin on the last job sold influence the margin we perceive possible on the next one.
If this strategy causes our margins to slip just 10% (from 40% to 30%), the revenue required to meet our overhead will increase by one third. And that assumes we don’t have to add overhead to deal with the increased volume.
The point here is to carefully consider the longer-term implications of reducing the price of a project in order to get the incremental profit which it might produce. If you are disciplined enough to add a job to your revenues occasionally by lowering the margin on only that job, it can be plus income for your business. It can also trigger some very unpleasant results if you do not fully understand the potential impact on your future pricing options or those of your competitors!