By Steve Milano Updated January 25, 2019
The two main reasons for a decline in operating profit are fairly easy to pinpoint – you either have a decrease in sales or an increase in expenses. Understanding the different reasons these occur can take more digging before you can stem the tide of profit erosion. Understanding common factors that reduce business profits will help you take steps to address them and spot problems quickly before they get out of hand.
Operating Profit from Core Business
It’s possible to lose money on sales and still make a profit, depending on your sources of income. Operating profit refers to the money you make on your core business, such as making and selling a widget. If you sell $100,000 worth of widgets, but your manufacturing and overhead costs are $110,000, you have an operating loss of $10,000. If you make $25,000 from royalties, investments or asset sales, you can still show an overall business profit.
Declining Sales Revenue
An obvious reason for a decline in operating profit is a decline in sales. However, it’s possible to increase your sales revenues and suffer a profit decrease. This can occur if your sales increase comes from higher sales of low-margin items while you suffer a decrease of sales of high-margin products. Even during good times, it’s important to track your sales by margins, territory, distribution channel and sales rep to spot trends that might lead to problems.
Increased Overhead Expenses
Another common reason for a decrease in profits is rising costs. Even if your cost to make a widget doesn’t increase, you might have increasing overhead costs, especially as you increase the pay of long-term employees each year. If your manufacturing and overhead costs remain the same and your sales are good, you can still see profit erosion if your debt-service costs increase. For example, missing a payment on a credit card can raise your interest rate and payments significantly.
Addressing Profit Erosion
Financial reports help you project income, expense, cash flow and debt service, allowing you to take steps to manage each of these critical areas. Divide your expenses into manufacturing and overhead expenses if you haven’t already. Manufacturing expenses include any costs directly tied to producing your product or service. Overhead costs are those you accrue to run your business, such as rent, phones, insurance, marketing and office supplies.
Track your manufacturing and overhead expenses each month as a percentage of sales to spot any large swings that indicate a problem. Even though credit card interest gets rolled into your balance each month, record it as an expense in your budget to get a true picture of your profits. Analyze your budget performance against your projections each month to determine if you need to adjust your spending based on faulty sales projections.
