The Keys to Profitability Might Be Different Than You Think
How a company drives profitability might seem complicated, but it doesn’t need to be.
Following your entrepreneurial dream is magical. What starts as an idea with some strong early execution, sprinkled with a bit of good timing and luck, is now a real-life revenue-generating company.
As a result, you start hiring team members and open an office, spending precious capital without understanding the impact these expenses will have on the business and its capacity to generate net profit.
Now, you are not a clueless operator. You watch revenues closely and review the resulting profit and loss statement (P&L) when it’s complete sometime next month. But making real-time decisions without real-time information is like playing tennis blindfolded.
While you don’t need to become an expert in operational finance in order to break even or increase profitability, you do need to understand two primary metrics that dictate how, and to what extent, the company generates net profit.
Yes, there is a little bit of math but it is simple, so bear with me as this is where the magic happens.
The importance of contribution margin
Contribution margin is, in fact, the silver bullet to profitability woes.
In order to calculate CM, which can be looked at as a dollar amount or a ratio, subtract the variable expenses from associated revenue. Note that variable expenses are the costs that exist when the company earns revenue, such as cost of goods sold (COGS), credit card processing, shipping and fulfillment, and marketing costs.
For example, if a company earns $10,000 in revenue with $6,000 in variable expenses:
● CM = $10,000 — $6,000 = $4,000
In order to convert that to a ratio, just divide the CM total by the revenue:
● CM = $4,000 / $10,000 = 40 percent
What does CM mean and how does it impact the business? More on that after we cover a key factor that crushes profitability.
The weight of fixed expenses
Fixed expenses (FE), as opposed to variable expenses, exist whether the company generates revenue or not. Typical examples include payroll, office rent, health insurance, and interest on debt.
If the business is having trouble turning a profit, look at fixed expenses as these are often the first to get out of control.
How? Payroll, office, and debt-related expenses are the primary culprits, which are often added without a clear understanding of how revenue, or more specifically contribution margin dollars, must increase to pay for them.
How contribution margin and fixed expenses interact
So, where do we go from here? Pay attention, this part is critical.
Contribution margin is the dollar amount that pays for, or “contributes” to fixed expenses. Any contribution margin dollars that exceed fixed expenses are the net profit.
In other words: net profit = contribution margin — fixed expenses
That said, there are two primary ways to maximize profitability within a company:
- Increase the amount of contribution margin dollars coming in, to maximize the amount that exceeds the fixed expenses, thereby increasing the net profit.
Do this by becoming more efficient with advertising dollars. Remember that advertising expenses are variable, so driving the same revenue with fewer marketing dollars increases contribution margin.
Another option is to increase sales revenue without significantly reducing return on ad spend (ROAS). There is more complicated math to show how far ROAS can adjust while maintaining the desired revenue outcome, which our Pentane system automatically calculates in addition to a real-time profitability dashboard.
- The second way to impact net profit is to decrease the amount of fixed expenses in the business, reducing the required amount of CM dollars to cover these expenses and making it easier to get to break even or maximize net profit.
Ultimately, the key to creating a healthier and more profitable business is to focus on driving more contribution margin dollars and controlling fixed expenses. Execute these with access to real-time data, and watch magic happen.
*This article was written by me (Adam) and previously featured on Inc.com
