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:
- Unit selling price
- Unit cost
- Unit sales
- 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
|Gross margin %||53.3%|
|Cost of sales||175,000|
|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.
- The unit selling price is increased by 3% from 15.00 to 15.45
- The unit cost is reduced by 3% from 7.00 to 6.79
- The unit sales is increased by 3% from 25,000 to 25,750
- 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:
|Gross margin %||56.1%|
|Cost of sales||174,843|
|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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.