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Every company has profit leaks-areas where inefficiencies are draining cash and profit from the business. The challenge facing business owners and upper management is how to identify and fix those leaks. But first you need to determine how much additional profit is available in your company. It might be thousands or even millions of dollars, so challenge yourself to improve your business and increase profitability by that amount.
Finding the Upper QuartileMany business owners don't realize that more profit is available at their current level of sales. Let's say that your bottom line has been stuck at 3% for years. Over time, you have come to accept this as the norm, but is that really the best you can do? How do you know what your competitors are making on their bottom line? More importantly, what realistic, achievable profit targets should you be aiming for?
The first step is to look at how your profit performance compares to that of your competitors-particularly those in the upper quartile. The upper quartile companies are the top 25%, or the best-in-class performers. Profit ranges for the upper quartile are usually between 8% and as high as 20% (pretax), depending on the industry sector.
Under the North American Industry Classification System (NAICS), previously known as the Standard Industrial Classification (SIC) system, every industry and business type is assigned a code for reporting purposes. For example, a manufacturing company producing brick and structural clay tile would fall under the SIC code 3251 or NAICS code 327121. The standards for upper quartiles are compiled by the Risk Management Association (RMA), and the data is sorted by the SIC/NAICS code and sales revenue. The total profit margin is calculated by adding the owner's salary and pretax profit. The companies with the highest combined percentages are in the upper quartile and are the "best of the best" in their industry. This process levels the playing field and allows privately owned companies to be ratted equally by sales level.
Many companies use industry trade association data as their benchmark. However, this data is often flawed due to poor reporting from the members in the association and/or a lack of data from non-members. The data is usually an average of the best-of-the-best and worst-of-the-worst. In comparison, the RMA compiles data provided by banks and evaluates actual income statements and balance sheets from thousands of actual bank loan customers. The data is then sorted in quartiles to determine the most profitable companies.
Capturing the SavingsHow can you use the RMA data to identify your profit targets? First, check the top page of your corporate tax return to get your specific SIC or NAICS code. To obtain the upper quartile data for your industry free of charge, visit your local library and ask for the RMA Annual Statement Studies reference books.* You can then compare the upper quartile profit and owner salary percentages to yours to see the profit gaps in your organization.
For example, if your pretax profit is 3%, and owner's/president's salary as a percentage of sales is 2%, then your total profit is 5%. If you compare that to the upper quartile threshold for the SIC code 3251 of, say, 12%, you'll see a 7% profit gap. If you have $10 million in annual sales, your new target to become a best-in-class performer is $700,000 of additional profit over your current profit of $500,000.
You should also compare the RMA data to your income statements and balance sheets for the past three years, year by year, and do an average for all three years to get an overall picture of how your company is performing compared to the upper quartile.
If your research indicates that there are savings to be captured, then perhaps you have an informal management process. Symptoms of an informal management process include tight cash flow, product quality problems, low employee productivity and morale, lack of operational control, low profitability, unrelenting stress, worry, and never achieving your business or personal goals. We express the target amounts as "savings to be captured" rather than "profit lost" because the amount indicates what would happen in the future if a proper formal management process were put in place. A formal management process, like the Cycle of Success and other business methodologies, places a company in the best position to improve, grow and handle changes in the marketplace.
This new bimonthly series of columns is designed to help you improve the operations inside your company, manage for higher profits and improve the morale of your employees. My next column (scheduled for April) will include an employee survey that can help you quickly gather a wealth of information on your organization, and future columns will provide you with additional analysis tools that can improve any business.
With a formal management process and the right tools, you can increase the success and profitability of your company.
*Data from the RMA Annual Statement Studies reference books can also be obtained online through the RMA for a fee. Visit http://rmaweb.rmahq.org/RMA/ and click on "RMA Bookstore" for more details.