Can a business increase sales 10 per cent, keep expenses constant and still see a significant increase in profits?
Conventional business looks at sales from the standpoint of three variables, namely sales, expenses and profits defined by the formula: sales – expenses = profits. In this approach, each variable depends on the other, forcing businesses to look at either increasing sales or decreasing expenses in order to influence profitability.
This familiar but simple formula offers a narrow view.
This week, I’m introducing a broader formula that breaks the sales variable into five separate components, providing much deeper detail. These variables offer a business owner significantly more data and can be worked individually and across the board to leverage profits on the bottom line.
The Five Ways formula is the business “chassis,” therefore no matter what size or scale, any business can use this formula.
Five key, profit-generating areas drive business: lead generation, conversion rate, average dollar sale, average number of transactions and profit margins.
Lead generation x conversion rate = number of customers
Number of customers x average dollar sale x average number of transactions = revenues
Revenues x profit margins = $ profits
A closer look at each of these five variables reveals how an increase in any or all of them can increase sales and profits, while keeping expenses constant.
Understanding lead generation, conversion rates and average dollar amounts
In today’s economic reality, business owners cannot sit back and expect to see profits roll in. It’s vital for businesses to test and measure every area by recording activity in each of the five areas.
Leads are often defined as the total number of potential buyers, or prospects, that a business contacts over the year. However, the number of contacts and responses you make won’t necessarily translate into converted sales.
Track your conversion rate, or the percentage of people that did buy versus those who could have bought.
An example of this is 10 people walking through your door with three people buying something.
On that day, the conversion rate was three out of 10, or 30 per cent.
Multiply the number of leads by the conversion rate to get the total number of different customers.
The average number of transactions is the number of purchases each customer will make over the course of a year.
This information should be kept in a database. Don’t subscribe to the myth, “Once a customer, always a customer.”
The average number of transactions is closely related to the average sale of each purchase.
Discovering revenues and working on margins
Revenue is computed by multiplying the total number of customers by the number of times each purchased from you, multiplied by the average amount they spent. The resulting number is the total value of overall sales for the business.
Margin is the profit percentage of each and every sale. Simply put, if a business sells something for $100, and $25 was profit, the profit margin is 25 per cent. The final step takes the resulting revenue number and multiplies it by a company’s profit margin percentage to reach bottom-line profit.
The Five Ways model can be used by businesses to leverage one or all of the variables in the equation. Any business can work with the variables to improve the bottom line, even ones that offer products or services with a long-term buying cycle or a limited number of transactions.
When used consistently, this business tool will highlight the areas that should be included in future planning. It may indicate that more marketing is required to capture more qualified leads, or more initiatives developed to increase conversion rates, raising prices to leverage the average sale amount, or upgrading profit margins.
If you can just increase each of these five areas by 10 per cent, your profits will increase 61 per cent.
In future columns, I’ll concentrate on each of the five areas and discuss several simple strategies any business can implement that will improve the bottom line.
The formula can be challenging. By putting in numbers, you soon see how one area impacts the other.
Feel free to contact me for more clarification.
John MacKenzie operates ActionCOACH in Red Deer, helping small- to medium-sized businesses in areas like succession planning, systems development, sales and marketing, and building/retaining quality teams. MacKenzie’s blog can be found at bprda.wpengine.com and he can be contacted by email at firstname.lastname@example.org or by phone at 403-340-0880.