The Finance Triangle

What do the numbers mean? Some managers feel insecure when it comes to challenging the numbers presented by the accountants and financial analysts. The numbers don’t need to be mysterious.

Numbers are the measures – the scorecard of what’s going on in the business. The financial numbers are the raw material of budgets, balance sheets and income statements. A senior manager states, “Financial measures are like the gauges on the dashboard of your car. They measure what’s important. The feedback helps you focus, take action, and make adjustments as needed.” It’s important to understand both the numbers that describe the current situation and the trend — how the numbers have changed over time.

Tim Still, Vice President, Annuity Servicing, The Travelers, states, “Companies have three basic goals: 1. Increase sales; 2. Reduce expenses; and 3. Increase operating profit.” Managers need to understand the relationships between and among these three variables.

  • Profit
  • Sales
  • Expenses

Profit

It’s the famous “bottom line.” Add up your sales subtract expenses – what remains is profit. Profit is good; the more, the better. The word “profit” comes from the Latin word profectus, meaning advancement or improvement. Profitable companies have the money to reward people, invest in new technology, and develop new products. An executive remarks, “People want to be part of a successful company. One measure of success is making a profit.”

Start-up companies often lose money their first few years of operation. However, you can’t go on losing money for long. Unfortunately, many new internet companies didn’t realize this rule applied to them.

Profits measure two things:
1. The extent to which customers buy your products and services.
2. How efficiently the business produces and delivers its products and services.

One manager states, “At the top of my ‘to-do list’ are the action items that will increase sales and reduce cost. Both impact profit. It’s the difference between sales and expenses that is the true measure of success.”

Making a profit is important. Companies make the point very clear when they implement profit-sharing programs. When 30% of your compensation is based on profit, it motivates you to work smarter and harder at both increasing sales and cutting costs.

Sales

More sales equals more profits, assuming you make some profit on each dollar of sales. How do companies increase sales? They do one or more of the following:

  • Increase sales of current products to current customers.
  • Increase their customer base.
  • Develop new products and services for current and/or new customers.
  • Increase the number of uses for their product.

The approach you take to increase sales ties back to your mission and vision. What’s your business purpose and where are you going?

Growth in your top line from sales shows that customers are increasingly valuing your products. However, many companies grow their costs as quickly as their sales, so they don’t profit. The best companies learn to increase sales volume without increasing fixed costs.

The best companies are continuously improving their processes to identify, develop and sell great products. Here are a few things they do:

  • Observe customers. Ask questions. What problems do they have? What new products would make their lives easier?
  • Brainstorm. Generate lots of new ideas. Ask “what if” questions. Always be searching for the next big idea.
  • Simplify. Make it easy for customers to understand in what ways your products are different and better than the competition.
  • Make it easy to buy your products and services.
  • Give yourself a phone call. Experience what your customer’s experience.

Bottom line – managers must constantly look for and find ways to increase sales.

Expenses

Think of expenses as costs incurred to produce and sell products and services. First, you need to understand the sources of all costs. Companies that have the best success in cutting costs focus on the right target areas. In addition, they simplify and improve their processes so new costs don’t show up elsewhere in the organization.

Bob Fifer, author of Double Your Profit, maintains that there are two types of costs:

  • Strategic costs – all the things done to bring in new business such as advertising, sales reps and promotional programs.
  • Non-strategic costs – all the costs necessary to run the business such as rent, utilities, and office supplies.

His philosophy is to spend more than the competition on strategic costs. But don’t waste money; spend it on the “right things.” Ruthlessly cut non-strategic costs to the bone. Cutting costs – budget cuts and downsizing – isn’t fun work but it is necessary. Profits can be equally impacted by increasing sales or by cutting costs.

Eliminating costs starts with having the right mindset. For example, have the attitude that there are no such things as “fixed costs.” This arbitrary designation conveys the meaning that a “fixed cost” can’t be reduced. Not true. All costs can be eliminated or reduced.

Here are a few suggestions on cutting costs:

  • Before hiring additional people, analyze your current staff’s productivity.
  • Eliminate all unnecessary reports, procedures and meetings.
  • Cut budgets aggressively. If you cut too far, you always have opportunities to correct your mistakes. On the other hand, if you spend too much, that money is gone forever.
  • Attack the price you pay suppliers.
  • Analyze the R&D budget. Is the money being spent effectively? Is it leading to new products customers will buy?
  • Reduce inventory. As inventories are reduced, you need less space and fewer people to manage the inventory.

Bottom line – managers must constantly look for and find ways to cut costs. Mike Tenerowicz, professor and small business advisor, states, ” I’m constantly telling clients to answer these questions before making any purchase: Will this purchase help you increase sales? Will this purchase make your business run more efficiently?”

Relationships (Ratios)

Ratios simply show the relationship between two things. Within each of the variables (sales, costs and profit) there are a number of factors that can be compared. Here are a few examples:

Sales

  • Sales/Employee
  • Average sales/Customer
  • Sales of product A/Sales of product B
  • Net sales/Assets

Costs

  • Fixed/Variable
  • Material/Labor
  • Benefits/Direct labor

Profits

  • Sales/Service
  • Product A/Product B
  • Net Income/Net sales

Other ratios that are often used to analyze a business include:

  • Quick Assets/Current Liabilities – Quick assets are cash and accounts receivable. This ratio indicates the ability to pay current bills.
  • Profits/Sales – This ratio indicates the relationship between profit and sales. It answers the question, “For each dollar of sales, how much profit is generated?”
  • Debt/Equity – This ratio shows the relationship between the amount of money provided by creditors and the assets being provided by the owners of the business.

Summary

Keep your eyes clearly focused on sales, expenses and profit. These three variables are interconnected. Watch for changes in either sales or expenses. It’s important for managers to measure, monitor and understand trend data and important ratios. Be curious. What relationships will help you gain new insights and understanding of how the business operates.

Applying the Concept

Chris Manolakis, President, Abbett Business Services, Inc.

My company provides finance and accounting services to approximately 60 businesses. A key part of my job is advising business owners on what to do to impact the bottom line.

Increase sales – I tell my clients to view their business as a “V”. The bottom of the “V” represents their core products and services. You have to stay grounded in what you do well, but also look for new ways to help your customers. Another way to increase sales is through co-branding. If you run a gas station or convenience store, consider leasing out space for a Dunkin Donuts, Blimpie’s or Subway operation. This can be a win-win deal.

Managing expenses – People who start a business often struggle, sacrifice, and scrape by for a year or two. When sales start to take off there is an entitlement attitude – “I sacrificed, I’m entitled to a new computer, secretary, car, office, etc.” That’s a dangerous attitude. Expenses can grow quickly. Little expenses can get overlooked once you start making some money. I had a client whose long distance phone charges had grown to 62 cents per minute. With some negotiations the business owner was able to reduce it to 7 cents per minute. Managers need to realize scrap, rework, and pilferage impact your expenses. If you’re operating on a small profit margin think about how much you have to sell to make up for a $50 loss. Constantly look for ways to cut expenses, but don’t cut the wrong expenses. Spend money on things that generate sales and lead to profits.

I coach business owners to keep a focused eye on both sales and expenses.

Applying the Concept

Steve Topor, Vice President and General Manager, Unisource

Unisource is a national distribution company with divisions in all major markets in the United States. We serve a broad cross-section of businesses with three principle product lines that include printing & imaging paper, industrial packaging supplies, and facility supplies. As a general manager, I have P&L responsibility for the division in northern California.

As part of our income planning process we have targets for each corner of the finance triangle – sales, expenses, and profit. In order to achieve a given increase in profit, we need to drive it with additional sales and a limited amount of additional expense. This process helps clarify the type of customer we must pursue. “Any customer is a good customer” isn’t true. A $100 order from the local gas station isn’t what we’re after. Our cost structure and business model require that we target large customers who generate large orders.

The sales function is responsible for driving sales growth by hiring, training, and motivating our sales force. Our compensation structure is designed to reward sales reps for growth. There are additional incentives that promote the growth of certain products that generate higher profit margins. These tactics are used to motivate reps to reach their goals and the company goals. Once we have customer orders, the operations function is responsible for the assembly and delivery of the products. Our costs are based largely on warehouse and driver staffing levels, the productivity and quality of their work, and the cost to operate our fleet. All of these costs are closely managed.

Operating profit is very sensitive to changes in sales and/or expenses. As sales change up or down, corresponding changes must be made on the expense side of the equation. Otherwise we will not achieve desired profit levels. We have a system called “dashboard indicators” (like the dials on your car dashboard that measure speed, fuel, mileage, etc.) to monitor the “vital few” factors that have the most significant impact on the bottom line.

NBA coaches enter each contest with specific goals and a game plan. As the game unfolds, they make many adjustments based on factors, such as what plays are working and not working, player fouls, turnovers, and who’s scoring. In a similar way, I need specific goals and a game plan for sales, expenses and profit. As the year unfolds, I have to make the right adjustments to be successful.

© 2002 – 2014, Paul B. Thornton. All rights reserved.

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