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Profit maximization might be the most misunderstood concept in business. After all, doesn’t it make sense to increase sales as much as you possibly can? Won’t profitability automatically come with those increased sales? It seems counterintuitive, but the answer to that is actually no.
So, how do you attain profit maximization? While it’s not as easy as simply increasing sales, it’s not as hard as you might think.
To understand the future, we have to go back in time. So, before we go any further, let’s take a quick trip back to Microeconomics 101. Don’t worry—the professor can’t see us, so he won’t call on you for an answer.
Profit maximization is the ideal level of sales, where your business achieves the highest profit. So, what does that mean? The professor is writing some fancy calculus equations on the overhead projector to explain this concept, but here are the key points in plain English:
When you are in the trenches and running your business, it’s easy to focus on the immediate need, which is often getting more cash into your bank account. But now that we have been reminded about the concept of profit maximization, we can see where we might have made some missteps. Now, we just need to fix them.
We now know higher sales do not always lead to higher profits. The biggest trap I see small business owners fall into is thinking they need to discount their prices, so they can increase their sales, so they can pay their bills. This happens because cash flow is tight, and discounting prices to increase sales volume seems like an easy solution. Unfortunately, this leads to more problems down the road.
Frequently discounting your product or service can lead your customer base to engage in purchasing behavior that results in a sustained lower profit margin. This means less money in your pocket and less money available to run your business. It also takes you further away from profit maximization.
How do we find that sweet spot where costs are lowest in relation to our revenue? What follows are a few tips that don’t require a refresher in calculus (yes, I noticed you have been on edge since the professor used the word “derivative” during our time-travel adventure).
I don’t mean discounting your products or services. Look for available discounts from your suppliers. The most underused discount I see in my work with small businesses is the early payment discount. Often, a vendor will give you a discount—usually ranging from 1% to 5%—if you pay their bill within 10 days. You can sometimes also get a discount for prepaying. Ask your suppliers if they offer discounts for early payment.
This is a common area of profit leakage in service businesses. We spend too much time doing things that could be automated or streamlined. Even if you run a service business that bills for outcomes instead of time spent on a project, time is still money. You have to pay your staff or subcontractors. Don’t have staff or subcontractors? Your time is valuable, too. Any unnecessary time you spend working on a deliverable is time you aren’t spending managing your business and preparing for future growth.
Profit maximization puts a lot of focus on the cost of the sale, but your operating costs are just as important. Aside from certain services businesses (architecture and engineering firms come to mind), most small businesses do not factor in burden rate. Burden rate is the allocation rate for indirect costs to direct costs, and it can be a real eye-opener when you are trying to achieve profit maximization.
As I mentioned above, when faced with a cash flow shortfall, many—I would go so far as to say most–business owners run a sale or discount their services to get more cash in the door. This is a short-term solution that usually leads to long-term problems. Effectively managing your cash flow on the front end using a cash management system like Profit First will help you avoid this common pitfall.
It is so hard to avoid the temptation to close every sale, no matter what concessions you have to make to do it. Especially when your business is in the early stages, you want to grow it as fast as possible. Here’s a hard truth, though: top line revenue growth is a vanity number. If you are only focused on growing your top line, and you are ignoring what steps you need to take to sustain that growth and reach profit maximization, you could be heading for disaster. Sometimes you have to say no to growth for the health of your business.
Though often ignored due to the complexity with which the subject is approached in economics, profit maximization isn’t a mind-bending mystery. By developing an awareness of your business as a whole, resisting the temptation to grow indiscriminately, and implementing the steps outlined above, you can easily attain profit maximization in your business.