Part Time Finance Director London Advice: Rising Prices Cut The Margin For Error In Your Business!

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in Cash Injection Tips, Part Time FD London

Business is currently a struggle for many business owners. First there was the impact of the economic recession. Now we all face rising costs as energy and commodity prices bite resulting in higher prices from suppliers.

So how should we pass those price rises on to our customers?

If we do nothing, price rises will cut into profit. This is dangerous since falling profit means that a business needs to generate higher sales volumes to cover its fixed costs, and less cash.

This is best shown by an example.

Let’s assume you have a business with sales of £1 million, a gross profit percentage (gross margin) of 40%, and overheads of £400,000. The business is trading at break-even, making neither profit nor loss.

If supplier costs rise by 5%, from £600,000 to £630,000, all else being equal the gross margin will fall from 40% to 37%. The business starts to make a loss of £30,000 per annum.

Assuming you can’t change to a lower cost supplier and you don’t want to absorb the extra cost which (in the example) would result in a net loss, the reaction of many business owners is to merely pass the value of the price rise on to the customer.

With costs increased by £30,000, the simple solution is to increase sales to £1,030,000, putting up prices by 3%. This will restore profitability to what it was at the start.

But this is the margin trap or error!

You see, although profitability has been restored, the original gross profit margin of 40% has not. You are now making gross profit of £400,000 on £1,030,000 of sales, but at a lower margin of 38.8%.

Declining margins are one of the key indicators in failing businesses. It’s therefore  vital that when suppliers increase their prices to you, you try to pass on the same percentage price increase to your customers to retain your starting profit margin.

So in the example given above, if your costs are now £630,000, you should increase your turnover by £50,000, through a 5% price increases to customers, in order to maintain the margin at 40%.

It may seem strange that you’re now making £20,000 extra net profit (£1,050,000 – £630,000 – £400,000). But if you don’t pass on price rises AND keep your up profit margin, it’s likely to be extremely damaging to your business over time.

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Until next time ……

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