Grow revenue or cut costs to increase profits?
There are two ways to grow your profit. You increase your turnover, ie sell more products or services. Or you reduce your cost of delivering your product or services. What is the best way to get a higher profit?
To answer that question, we have to take a short look at our costs, as not all costs are created equal. Roughly put there are two main types of costs, variable costs and fixed costs. Variable costs vary with the quantity of products or services sold. Examples are the material or production costs, man hours needed to create the product or service, delivery costs, etc. If you would double the number of products you sold, this cost would also double.
The fixed costs are, as the name implies, fixed. Typically, it is a set amount per time, for example per month, that is not influenced by the quantity of products sold. Your salary is one, your book keeper, the building you rent are some other examples.
To clarify this, let’s look at an example of the cost of a product or service in the image on the right.
In red we have the fixed costs, orange are the variable costs and the green is the profit.
This is just an example, so for your business the fixed costs might be a bigger portion than the variable costs or the other way around.
Typically, the profit is a small part of the whole, but it is the most important part. If it would be zero, there is no point in selling the product. If the profit is negative, then you run the risk of going bankrupt.
In the example on the right the fixed costs are 45%, variable costs are 45% and profit is 10%, so you earn 10 euro of profit for every 100 Euro of turnover.
THE MOST IMPORTANT ONE!
is to increase the profit, the green slice.
Let’s first look at cutting costs. Suppose you can cut the variable costs in half, so by 50%. Your profit would increase from 10% to 32,5%, see the image on the right.
If you had a business with €100.000,- turnover, you would have grown profit from €10.000,- to €32.500,- of profit. That’s not bad is it?
But how realistic is it that you can cut your variable costs in half, without affecting your turnover?
Now have a look at when you focus on revenue instead. When you increase your revenue the variable costs as a percentage stays the same.
But the fixed costs as a percentage starts to drop. The rent you pay is spread over more products or services, so the cost of rent for each product or service is lower.
Say we double the turnover to €200.000,-. If our amount of fixed costs stay the same, the percentage of fixed cost would half, so we get the image on the right.
Again the profit margin increases from 10% to 32,5%, so what’s the difference with cutting cots you say?
Well… we also doubled our turnover.
So our profit is actually 32,5% of €200.000,- which is €65.000,- euro.
That is more than 6 times the profit we had originally!
WHAT YOU NEED TO DO
What do you think is more realistic, cutting costs in half without affecting your revenue? Or doubling your revenue?
Doubling is more realistic, believe me. I’m not saying it is easy. But it is still more realistic than cutting costs in half. I grew the branch office I managed from 1,5 Million euro to 4,5 Million euro in three years. Can you imagine what that did to our profits?
And aside from the financial benefits of revenue growth, it is much more fun working in and for a growing business than for a business that is constantly trying to cut costs. Just ask the people at Ryan Air.
In the future, when you spend hours and hours on reducing your costs or saving a little bit by haggling with suppliers, ask yourself. Have I spent as much or more time on growing the revenue?
What are you going to do to grow your revenue? Let us know in the below comments section.