Most business owners and CEOs want to grow their top line, and many do something about it (launching new products, hiring more salespeople, investing in marketing and driving more revenue from their existing customers.) As their Chief Financial Officer, I put a focus on growing profitably.
There are two ways to make sure your grow your bottom line while putting an emphasis on increasing revenue. The first is to make sure that you are selling more of your most profitable products and services, and the best way to do that is to understand your costs of goods sold and your gross profit margin. For those not familiar with those terms or how to determine them, here’s a recap using an example of a company with two products
Product A Product B
Retail Price 100.00 100.00
Costs of Goods Sold
Direct Costs* 40.00 80.00
Shared Costs** 10.00 10.00
Total Costs of Goods Sold
Gross Profit (Retail Price less CGS)
Gross Profit Margin (GP divided by Retail Price)
*Direct costs are those that are incurred each time a new product is produced or provided. If your product is tangible, this would include your raw materials and manufacturing costs per unit.
**Shared costs are incurred to produce or provide your service but do not increase a certain amount each time a new product or service is provided. Instead, your company might incur a cost that is shared amongst many customers but is not limitless. To distinguish a shared cost from overhead, ask yourself whether you would have any cost if you had no customers or revenue.
In the example above, the gross profit margin of Product A is 50% while the gross profit margin of Product B is 10%. For every $100 of Product A sold, $50 of gross profit is generated, but for the same amount of sales Product B, your company would only make $10 of gross profit. What becomes obvious at this point is that growing sales of Product A will lead to higher profits and higher enterprise value than growing sales of Product B.
Continuing our analysis of the growth in sales among these two products, we also need to consider the sales and marketing costs related to the sale of each product. If you have a 20% cost of sales and marketing for both products, then selling more of Product B will actually cause a decrease in your profitability. While reaching this conclusion is obvious once you know your gross profit margin per product/service and your cost of sales (or acquisition cost), it’s vitally important that you pay attention to these things before you embark upon your growth initiative.
The last piece of the equation is your overhead. After focusing on sales of products and services that produce a strong gross profit that more than covers the costs of sales, you need to keep your overhead as stable and as low as possible. The math is obvious, so I won’t bore you with an example. Restricting the growth in overhead is the challenge. As more customers are sold and onboarded, there is likely to be pressure from front-line workers and their managers to increase headcount. While some growth in headcount may be necessary to support the increase in revenue, there should also be significant synergies from volume. To the extent your business and products truly require X number of people to support Y dollars in revenue or number of customers, then it’s important that you factor those costs into your gross profit analyses as shared costs. While accounting rules may not allow your accounting department to put the costs for these people in Costs of Goods Sold, you must determine ahead of your growth whether there is sufficient revenue to cover all of the variable costs of delivering that product or service.
In conclusion, growing your top line is typically a means to an end—more cash flow and/or higher enterprise value. If your goal is greater cash flow, look at how your costs will increase as you grow your revenue and determine if the revenue growth will make you more profitable. If your goal is higher enterprise value, know that while some companies are valued at a multiple of operating income (or EBITDA in accounting-speak) and some at a multiple of revenue, higher gross margins and higher total profitability will have a positive impact on your value.
If you or someone you know would benefit from a discussion about how to drive higher profits while growing your topline, please contact me at llevy@CFOoptionsinc.com.