Why to Learn How to Assess Revenue
Wall Street judges you on it. Shareholders demand it. Management scrambles to make it happen. Revenue growth is the mantra of modern-day business. Quarter by quarter, the pressure is on for sales numbers to increase. But the question at hand should be: “Is your bank account increasing?” Are you profitable? You may be surprised to learn after assessing your revenue that increases don’t necessarily translate to profitability. There is a very distinct difference between the two.
The difference between profit and revenue.
As is true with most businesses, the common thought within the industry is that profitability is tied to volume. Au contraire! Let’s get out the calculators and do some business math.
For the sake of this exercise, we’ll assume an operation has two customers for whom internal manufacturing costs are $20.00 per widget. A manufacturing reserve fee (much like a retainer) is $500 per month. Customer A has an order volume of 500 widgets per month and will pay $25.00 per widget for a total revenue of $13,000 or $26.00/widget (500*$25=$12,500 + $500=$13,000 $13,000/500=$26.00).
Customer B has an order volume of only 100 widgets per month and will also pay a manufacturing reserve fee of $500 per month plus $25.00 per widget for total revenue of $3,000 or $50 per widget (100*$25=$2,500 + $500=$3,000 $3,000/100=$30.00.)
Which customer account is more profitable to the processor?
At first glance, it may seem like a no-brainer. Go after the big volume customer that is paying more per widget. It’s the smaller customer; however, that will bring greater per widget profit.
The manufacturing profit for Customer A is $6.00 per widget ($26.00 – $20.00 = $6.00). The profit for Customer B is $10 per widget. $30 – $20 – $10). The bottom line is that Customer A has greater revenue, but Customer B has greater profitability. Revenue numbers may look good on paper, but profitability is what you have in the bank.
To make this simplified illustration one step further, we’ll consider the labor costs involved based on the assumption that the time required to process a widget for Customer A is the same as it is for Customer B. If the manufacturing operation had four more customers like Customer B – each with 100 widgets per month – the amount of labor and accompanying expense required to process these 500 widgets would be the same as that required to process for Customer A. Yet Customer B and the four other small customers would bring in a profit of $5,000. Compare that to the $3,000 profit made from processing Customer A’s 500 items. It takes the same amount of work to process the five small accounts as it does the one large one. But you get a bigger return (67% greater) with the smaller customers. The contributing factor is the manufacturing reserve fee. This accepted fee by both parties increases the per widget profitability of the smaller volume customer over that of the large volume account. The fact is that while a large volume account may generate more revenue for an organization, it may not be the most profitable course of action.
Still, it’s big numbers that get the attention of management.
Wall Street rewards revenue growth. However, a company could have a decrease in sales from one quarter to the next but see profitability climb. The irony is that unless revenue rises, stock prices fall. The truth of the matter is: profitability is the real indicator of a company’s health. An investor gets a dividend when profits are up – not just sales.
Nevertheless, many manufactures continue to turn down small accounts because they don’t understand the concept of profitability. Given the choice between a single account that will bring 500 widgets and 5 customers that generate 100 widgets each, a production manager will invariably choose one large customer. It’s easier to manage. And it’s easier for a sales associate to sell one high-volume account than to sell 5 smaller ones. When the numbers are calculated, though, it becomes clear that these are not sound business decisions.
Because incentives are based on revenue, salespeople will go to any lengths to win big-name, big-volume, and significant revenue accounts.
Seldom is the priority given to profit over revenue. Take any major industry and think of it as a pyramid. A limited number of companies usually occupy the top tier. Common practice is for most of the manufacturers vying for the business of those few top-tier accounts. Often, to win the business, a price discount is offered, further eroding the profitability. The “lucky” winner of these high-volume accounts may not be so lucky after all.
Not only has the price been driven down, but the manufacturer has more than likely spent quite a bit of time and money to compete for these deals.
A smart alternative strategy is to go after the companies in the lower two-thirds of the business pyramid. They are typically willing to pay full price than to bid down the price that manufacturers do with larger customers.
Another benefit of having several smaller customers than one large one is a risk. It is less likely that you will lose all your small customers at one time. The loss of one high-volume account has a much greater impact on your business than the loss of a single small volume customer.
Refocus on profit by understanding how to assess revenue effectively.
Understanding your business and working smarter are critical factors to achieving success. It is therefore essential that profitability considerations play a major role in business decisions. All decisions must therefore be based on profitability. That means shifting strategies and expanding the myopic view of revenue alone to include a focus on profits. Revenue on its own does not represent the vibrancy of an organization. Many of the past dot-coms serve as prime examples of companies that had millions of dollars on paper but incurred greater expenses than revenue earned. Lack of profit sent them to the annals of failed business ventures.
Perhaps it’s time to look at and approach business differently. Learn to effectively assess revenue, then you’ll make a new kind of history for the record books. One that will be emulated by others for years to come.