PBL Trigger 7

The seventh and final trigger is about financial accounting. Ken and Jimmy have had their business running for two years but they are not sure how profitable their business is and how to read the financial figures. 

We defined our problem as How to keep the business profitable?

1. How to understand an income statement and a balance sheet ?

Income statement

Summarizes the revenues, expenses and results of operations for a specified period of time. The difference between the revenues and expenses is identified as the net income or net loss.

Revenues (net sales) – Expenses = Income

Revenue is the “top line” amount corresponding to the total bene ts generated from business activity. Income is the “bottom line” amount that results after deducting the expenses from revenue. (Walther 2010.)

Balance sheet

The key financial statement is known as the balance sheet. It states the economic resources owned by an entity and the claims against those resources. It is prepared as of a specific date. It is sometimes said that balance sheets portray financial position (or condition) of the company while other statements reflect results of operations.

Assets = Liabilities + Owners’ Equity

Assets are the economic resources of the entity, and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible assets like patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner.

Liabilities are amounts owed to others relating to loans, extensions of credit, and other obligations arising in the course of business.

Owners’ equity is the owner’s “interest” in the business. It is sometimes called net assets, because it is equivalent to assets minus liabilities for a particular business. (Walther 2010.)

Ken and Jimmy's net income decreased in 2015 to 6 300€ from 9 100€. But more relevant for analysing how business is doing, is the balance sheet which portrays the financial position of the company. It grew from 59 300€ to 65 900€. Their retained earnings increased from 0 to 9 100€ and total equity from 11 600€ to 17 900€ while total liabilities increased only 300€, from 47 700€ to 48 000€. According to this, Ken and Jimmy did better in 2015 than in 2014 and their business is profitable. 

2. How to price product to make profit?

One of the secrets to business success is pricing the products properly. There are a variety of different types of pricing strategies in business. However, there's no one surefire, formula-based approach that suits all types of products, businesses, or markets. Pricing the product usually involves considering certain key factors, including pinpointing the target customer, tracking how much competitors are charging, and understanding the relationship between quality and price.

The biggest mistake many businesses make is to believe that price alone drives sales. The ability to sell is what drives sales and that means hiring the right sales people and adopting the right sales strategy.

Know Your Customer

Undertaking some sort of market research is essential to getting to know your customer. This type of research can range from informal surveys of the existing customer base sent out in e-mail along with promotions to the more extensive and potentially expensive research projects undertaken by third party consulting firms. 

Know Your Costs

A fundamental tenet of pricing is to cover the costs and then factor in a profit. That means it is essential to know how much the product costs. You also have to understand how much you need to mark up the product and how many you need to sell to turn a profit. The cost of a product also includes overhead costs. Overhead costs may include fixed costs like rent and variable costs like shipping or stocking fees. These costs have to be include in the estimate of the real cost of the product. 

A good rule of thumb is to make a spread sheet of all the costs needed to cover every month, which might include the following:

The actual product costs, including labor and the costs of marketing and selling those products.

All of the operating expenses necessary to own and operate the business.

The costs associated with borrowing money (debt service costs).

The salary of the owner and/or manager of the business.

A return on the capital the owners or shareholders have invested.

Capital for future expansion and replacement of fixed assets as they age.

Know Your Revenue Target 

It is good to have a revenue target for how much of a profit a business wants to make. If the company has a number of different products, overall revenue target needs to be allocated by each product. 

Know Your Competition 

It's also helpful to look at the competition. Are the products offered comparable to yours? If yes, look to see whether there is additional value in your product; do you, for example offer additional service with your product or is your good of perceived higher quality? If so, you may be able to support a higher price.

Know Where the Market Is Headed

Keeping track of outside factors that will impact the demand for the product in the future. These factors can range from something as simple as long-term weather patterns to laws that may impact future sales of your products. 

Monitor Your Pricing

Another key component to pricing the product right is to continuously monitor the prices and the underlying profitability on a monthly basis. It's not enough to look at overall profitability of the company every month. It is needed to focus on the profitability (or lack of profitability) of every product. 

(Wasserman 2010.)

3. What factors lead to long-term sustainability (profitability)? 

It is hard to achieve long-term profitability for any business. Even huge companies start making a loss eventually. According to Sherman (2017) there are three common characteristics of growth-oriented companies:

• Continuous innovation

• Meaningful differentiation

• Business alignment—where all corporate capabilities, resources, incentives, and business culture and processes are aligned to support continuous business renewal.

(Sherman 2017.)

When first establishing a new business venture, there are numerous steps to take to ensure that it is profitable. To sustain long-term profit margins, it is needed to create strategies that can be implemented regardless of any external, economic conditions and the performance of the chosen market. 

Pay Attention to Your Pricing

This requires some independent and creative thinking, however, as well as an ability to remain calm in the face of slow or diminishing sales. After all, it would be easy to react to stagnating sales with a series of volume discounts, but this can have a counterproductive impact on the businesses bottom line. 

In this respect, promotions and volume discounts should always be carefully considered based on consumer behaviour trends, rather than as a knee-jerk response to a sudden dearth of orders.

Interestingly, studies show that businesses with a viable value proposition and an existing consumer base actually benefit more by raising the prices, with McKinsey and Co. revealing that a single, 1% increase can lift operating profits by a staggering 11%.

Understand Consumer Behaviour

It is important to develop a clear customer profile for the target consumer, as this helps to predict their behaviour and ensures that the pricing is designed to capitalise on this. As a result of this, it is far easier to forecast potential peaks and dips in consumer spending, which in turn allows to create viable pricing strategies that maintain at least minimal margins at all times.

(Humphries 2016.)

Other factors to consider are: brand reputation, partnership and collaboration, repeatable sales, and flexible, adaptive leadership (Hoque 2015). 

Sources:

Hoque, F. 2015. The 7 Fundamentals Of Sustainable Business Growth. https://www.fastcompany.com/3049856/the-7-fundamentals-of-sustainable-business-growth. Accessed: 4.12.2017

Humphries, L. 2016. Long-term Profitability: How to Create a Sustainable Business Plan. https://www.careeraddict.com/long-term-profitability-create-sustainable-business-plan. Accessed: 4.12.2017

Sherman, L. 2017. How To Achieve Business' Holy Grail: Long-Term Profitable Growth. https://www.forbes.com/sites/lensherman/2017/03/10/how-to-achieve-business-holy-grail-long-term-profitable-growth/#4914c9b43dda. Accessed: 4.12.2017

Walther, L. 2010. The Four Core Financial Statements. http://bookboon.com/fi/accounting-1e-ebook. Accessed: 4.12.2017

Walther, L. 2010. Basics of Accounting & Information Processing. The Accounting Cycle. basics-of-accounting-information-processing.pdf. Accessed: 4.12.2017

Wasserman, E. 2010. How to Price Your Products. https://www.inc.com/guides/price-your-products.html. Accessed: 4.12.2017