Pareto’s Law applied to business likely will reveal to the entrepreneur that their business is serving (at least) two very different sets of customers/clients. And in trying to do so, he or she and their staff will suffer anxiety, frustration, and the loss of company profit.
So What is the Entrepreneur To Do When Pareto’s Law Applies?
First, I have found that most business owners are empowered by knowing exactly how their business’s two sets of customers/clients impact their Profit and Loss Statement.
So let’s start with the basics! Over the next four posts on this subject, you will need your calculator. Please don’t panic—none of you will have to take a test or need to call your Accountant. We are going to break down facts and figures in very simple terms found in your existing Profit and Loss Statement and Customer Sales records to shine the light on where you are making and where you are losing money. Ultimately, we don’t want you to leave money on the table.
Many people mistakenly believe only two figures matter on the Profit and Loss Statement. Every day you read in print journals and on the internet about Gross Revenues (the first figure at the top) and Net Profit/Loss (the last figure on the bottom). It is unfortunate that so much of the focus is on these two figures. A much more powerful measurement of profitability is buried in your Profit and Loss Statement and I believe it predicts the health, longevity, and ultimately the value of your business. This powerful measurement is the Gross Profit Margin.
Gross Profit Margin Definition
If you are not an Accountant or financial wizard, the term Gross Profit Margin may intimidate you. Let’s not let that happen—it is not that complicated!
The Gross Profit Margin is simply that portion (or percentage) of a dollar left over from a sale (the first figure at the top of a P&L Statement) after paying the direct cost to deliver the product/service to the customer/client.
For example, if you charge $1 for your product/service and you spend 30 cents to purchase, build and deliver the product/service, the difference between the two (what is left over) is 70 cents. Your Gross Profit Margin is 70%.
Don’t Delegate This!
The entrepreneur needs to know what her company’s Gross Profit Margin is and should monitor this percentage all the time. Expecting your Accountant to monitor this for you when you visit him or her once a year is too little AND too late!
The 70 cents that is left over (in our example above) is what the company has to work with to pay its operating expenses (salaries, office and plant costs, benefits, etc.). And if the gross profit margin is too low, there will be no money left over (profit) after paying the company’s operating expenses. And worse yet, if the operating expenses exceed the gross profit margin, then the company loses money.
It is very likely that each set of a company’s customers/clients have a different gross profit margin. Unfortunately, it is not unusual to find that the customers/clients who sit in the group which fall below the Pareto’s Law line, do not produce enough money to even cover the direct costs needed to purchase, build and deliver the product/services to them! This is a very dangerous situation!
When this is the case, you might as well not take the order, or service this client at all. In fact, you would be better off sending them a check instead. I’m not kidding.
In our next post, we will explore how to derive this information from your financial records so you do not leave money on the table.
Find Holly Magister on Google+
Holly also founded ExitPromise.com and to date has answered more than 2,000 questions asked by business owners about starting, growing and selling a business.
Latest posts by Holly Magister, CPA, CFP
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- How to Prepare for Due Diligence When Selling a Business - February 12, 2019