Countertalk: Knowledge Building: Three Rules of Profit

Arecent call from a jobber for some articles on gross profit to convey to the company’s staff prompted me to provide this quick review of the rules of profit.

The first rule of profit is that it is generated from two things: margin and volume.

If a part’s sales lack one or the other, there is no profit.

One of the funniest things I have ever read was published in a bulletin produced many years ago by a petroleum industry group. The bulletin stated that while service stations lost money on every litre of fuel sold, they made it up on volume. Assuming you are being honest, and not applying unreal economies of scale only to the real sales volume equation, this is not possible. Lose money on one, and you lose more on many.

Aside from the loss leader situation, as a counterperson you must ensure that you and the business you work for are pricing its products out to generate an appropriate profit.

How much latitude you have with pricing decisions depends on your business’ policies.

In either case, it is important to understand the relationship between margin and volume.

This is the second rule of profit: when margins drop, volume must increase to maintain dollar profit.

This seems obvious, but most people don’t appreciate how much volume must increase. It can be quite dramatic.

Using theoretical numbers for simplicity’s sake, let’s say you normally sell 100 brake calipers a month for $25 each. If they cost you $15 each, the gross profit per caliper is $10 each, and gross profit percentage is 40%. The total sales per month is $2,500; total profits are $1,000.

If you lower the price by 10% or $2.50, making the selling price $22.50, your gross profit per sale becomes $7.50 or 33.33%.

Before you read the answer, how many more calipers do you think you must sell to generate the same dollar profit?

Here is the formula:

Starting GP$/GP$ per piece = Total Units

Or

$1,000 / $7.50 = 133.3333 or 134 calipers.

The 10% reduction in price will require a 34% increase in sales to generate the same total gross profit as before the price reduction.

Here is the formula for calculating the increase in sales needed after a price cut.

Beginning GP%/ Beginning GP% – % Lowered -1 = % of Sales Increase Required

A 34% increase in sales for a single category of parts is pretty dramatic, possibly not attainable in today’s market, unless you are dealing with an impulse driven, discretionary purchase item, which most of the parts on your shelf are not.

Accordingly, it serves to illustrate how what might seem to be a small change can have huge implications on the bottom line. And how you can dig a very big hole in your profit picture very quickly if you don’t understand the impact of a change.

You should consider this every time you offer a customer an impromptu discount without sound reasons.

On the other side of the scale, however, the profit impact of a price increase can be equally as dramatic.

This is the third rule of profit: small increases in price generate large increases in profit.

This is true largely because there is no additional cost associated with a price rise, and the fact that the gross profit is itself only a portion of the selling price.

Using the same brake caliper example, but raising the price by 3% for a selling price of $25.75, generates a per-unit profit of $10.75, or 41.75% (up from 40%). This raises total gross profit on the existing volume of 100 calipers a month to $1,075, a 7.5% increase in gross profit.

Of course, you may lose a sale or two on the way, but this can be calculated too.

Beginning GP%/Beginning GP% + % Raised -1 = % of Sales Decrease w. Equal $Profit

Using our example:

40%/40% + 3% -1 = .0697 (a 6.97% drop in sales equals the same profit)

In our example, the actual dollar profit with the loss in volume is $999.75, so we sacrifice a quarter. And, just to be clear, a 7% drop in sales means losing about one sale in 15.

Whether that is what you are prepared to is something for each business to decide.

But, by considering these three simple rules, making a decision to increase or lower prices, across the board or on an individual customer basis, will at least be made knowing the real profit implications.