Improving Profitability in Financial Projections

The initial draft of any financial projection will probably not show the level of profitability (net income) you were hoping for. While this may reflect the reality of the situation, leading to the conclusion that the business is not a viable proposition, more often than not minor tweaks and amendments can result in significant improvements in profitability.

 

Don’t Underestimate Minor Changes

One technique of amending the financial projection with a view to improving profitability is to make minor percentage changes to four key areas of the income statement.

The four key areas in the financial projection are as follows:

  1. Unit selling price
  2. Unit cost
  3. Unit sales
  4. Operating expenses

Note: Although the objective here is improving profitability, there is no point in simply amending each area to obtain the desired net income without having regard as to whether the changes are realistic and achievable in practice.

Improving Profitability Example

Suppose a business has produced financial projections showing the following results.

Financial Projections Before Adjustment

Improving profitability: Unit product details before
Selling price 15.00
Cost 7.00
Gross margin 8.00
Gross margin % 53.3%
Improving profitability: Income statement before
Unit sales 25,000
Revenue 375,000
Cost of sales 175,000
Gross margin 200,000
Operating expenses 185,000
Net income 15,000
Net margin % 4.0%

The net income of the business is 15,000 resulting in a net profit margin of 4%.

The business is looking at improving profitability, and decides to make the follows changes.

  1. The unit selling price is increased by 3% from 15.00 to 15.45
  2. The unit cost is reduced by 3% from 7.00 to 6.79
  3. The unit sales is increased by 3% from 25,000 to 25,750
  4. Overheads are reduced by 3% from 185,000 to 179,450

In this example, the proposed changes adjust each of the four key areas by 3%. The adjustment does not have to be the same for each area, but it provides a useful starting point to see the impact of a relatively minor change.

When proposing the adjustments, the business must consider how it might make these improvements. For example, is the selling price of 15.45 achievable in the current marketplace, or can the unit cost improvement of 0.21 be achieved by better buying or a reduction in material and labor costs. Each adjustment must be considered in turn and a realistic proposal put forward as to how it might be achieved.

Financial Projections After Adjustment

Following the adjustments (highlighted in blue) the resulting financial projections are as follows:

Improving profitability: Product details after
Selling price 15.45
Cost 6.79
Gross margin 8.66
Gross margin % 56.1%
Improving profitability: Income statement after
Unit sales 25,750
Revenue 397,838
Cost of sales 174,843
Gross margin 222,995
Operating expenses 179,450
Net income 43,545
Net margin % 10.9%

Looking in detail at the impact of the changes we see the following:

  • The change in unit selling price and cost improves the gross margin percentage of the product from 53.3% to 56.1%.
  • The increase in unit sales increases the revenue which, together with the improvement in gross margin percentage, increases the total gross margin by 22,995.
  • The reduction in operating expenses saves a further 5,550 giving an overall increase in net income of 28,545 or 190.3 % of our original net income of 15,000.
  • As a result of these minor changes the net margin percentage of the business has improved from 4% to 10.9%

In summary, it can be seen from the projections above that a minor change in these four key areas of 3%, improves the profitability of the business by 190.3%.

Improving profitability will depend on the particular circumstances and nature of the business involved. However, the effect of relatively minor changes should not be underestimated, and can mean the difference between the financial projections showing a loss making, non viable business and a rapidly expanding profitable one.

If you would like to carry out your own calculations using the above technique, try our profit improvement calculator, which allows you to make percentage adjustments to product selling price, cost, unit sales volume, and fixed operating expenses, and then calculates the change in net income for the business.

Improving Profitability in Financial Projections October 5th, 2016Team

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