Mind Your Margins: Why Revenue Growth Doesn’t Always Mean Profit Growth

By Eric Kundinger,
Prevail Bank Vice President; Commercial Lending Officer – Stevens Point
715.254.0595

As a commercial lender, I spend a lot of time reviewing financial statements and talking with business owners about their performance.  As a business owner and investor myself, I also get to experience many of those same challenges firsthand.

One thing has become increasingly important in the current environment: minding your margins.

For many businesses, the problem isn’t necessarily revenue.  Sales may be steady—or even growing—but the cost of producing that revenue has increased substantially.  Labor, insurance, fuel, utilities, materials, interest expense, software, professional services and countless other expenses have all put pressure on the bottom half of the profit and loss statement.

Ultimately, it isn’t what you generate at the top that determines the financial health of your business.  It is what makes its way to the bottom.

A Few Percentage Points Matter

Consider a business generating $2 million in annual revenue with a 10% net margin. That produces $200,000 of net income.

If expenses gradually increase and that margin falls to 7%, the business is now producing $140,000 of net income.

Revenue didn’t change. The company didn’t lose customers.  From the outside, the business may look exactly the same.

But profitability declined by $60,000—or 30%.

That is why relatively small changes throughout a P&L can have such a significant impact. An additional 1% spent on labor, another 1% on insurance and another 1% spread across fuel, materials and other operating expenses can quickly consume a meaningful portion of your bottom line.

The danger is that these increases rarely happen all at once. They creep in.

Know Your Numbers Monthly

One of the simplest disciplines I recommend is reviewing your profit and loss statement every month—not simply at tax time or when your accountant sends year-end financials. Even better, look at each major expense category as a percentage of sales.

If labor historically represented 30% of revenue and is now consistently running at 34%, that deserves attention.  The same applies to materials, insurance, vehicle expenses, advertising and other major categories.

Compare those percentages month over month and year over year.

The purpose isn’t to obsess over every minor fluctuation.  It is to identify trends before they become permanent.

Comb Through Your Expense Profile

Periodically go through your P&L line by line and ask a simple question: Does this expense still make sense at its current level?

Labor is an obvious place to start.  Wages have increased significantly in many industries, and good employees are worth paying for.  Cutting labor indiscriminately can be counterproductive.

But you should at least understand what is happening to your labor percentage.  If compensation has increased faster than revenue, perhaps pricing, productivity, staffing levels or processes need to change.

Commercial insurance is another area worth reviewing.  Premiums can increase significantly from one renewal to the next.  Work with your agent to understand the increases, review deductibles and coverage, and periodically make sure the program remains competitive.

Then work through the rest of the business: merchant processing fees, software subscriptions, telecommunications, professional services, utilities, vehicle expenses, supplies, maintenance contracts, rent and other recurring costs.

Individually, many of these expenses don’t look significant.  Collectively, they can materially change your margin.

Sometimes the Answer Is Pricing

Not every increase in expenses should—or can—be solved by cutting costs. Sometimes your pricing simply needs to change.

If you’re operating a trucking, construction, delivery or service business and fuel costs increase materially, for example, you may need a fuel surcharge or another mechanism for passing a portion of that increase through to customers.

If labor and materials have increased 15% over several years while your rates have barely moved, there may not be enough efficiency improvements available to maintain your historical margins.

Business owners are sometimes reluctant to raise prices because they fear losing customers. That is understandable.  But there is also risk in maintaining prices that no longer support the economics of the business.

The important question isn’t simply, “Can I charge more?”

It’s “What does it actually cost me to deliver this product or service today, and what margin do I need to operate a healthy business?”

Protect the Margin, Not Just the Revenue

Revenue growth is exciting.  It’s easy to measure, easy to talk about and often gets most of the attention. But a business can grow revenue while becoming financially weaker.

That is something I pay close attention to as a lender, and it is something every business owner should monitor internally.  Sustainable businesses generate enough margin to reinvest, service debt, withstand downturns, compensate ownership and maintain adequate liquidity.

You don’t necessarily need a complicated financial system to accomplish that.

Review your P&L monthly.  Track your major expenses as a percentage of revenue.  Compare results to prior periods.  Understand where costs are increasing.  Regularly challenge recurring expenses.  And when costs have structurally changed, be willing to revisit pricing.

Most importantly, don’t wait until cash gets tight to start looking for the problem.

By the time declining margins become a cash-flow problem, your options may already be limited.

By the time declining margins become a cash flow problem, your options may already be limited. Know where your margins are going while you still have time to do something about it.

Want to see how your business stacks up against the competition? Contact your local Prevail Bank commercial lender for a complimentary Vertical IQ Industry Overview, including key industry trends, benchmarks, and peer comparisons.
 
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