First Person: Cut Expenses or Increase Sales?

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During the 40 months I was on the road as a small business consultant, one of the common perceptions of small business owners and managers was that they needed to increase sales to solve their financial problems. As consultants, we knew that we had to teach them how to increase profit the fastest.

After all, small business owners rarely spend the money to bring in consultants if they don't have a crisis situation. So increasing profits right away is vital. In such a situation, cutting expenses is actually more critical for the business' financial health than increasing sales.

In a Financial Crunch, Increasing Sales May Take too Long

I have over 30 years' experience and expertise in sales and marketing so, naturally, I believe in the importance of increasing sales. Nevertheless, that approach is a long term solution. Here's why.

When you cut expense, you immediately increase profit by the amount saved. To appreciate this, you need a basic understanding of your profit and loss statement (P&L). In this example, I am using very small numbers to more easily show the impact of $1 saved by cutting expenses. You can follow this formula to see how it works for your business with larger numbers.

Simple Profit and Loss Statement for Cutting Expenses Example

Sales

-Cost of goods sold

Gross profit

-Expenses

Net profit

$100 in sales

-$83 in cost of goods sold (83%)

$17 in gross profit (17%)

$17 gross profit (17%)

-15 in expenses and overhead (15%)

$2 in profit (2%)

By Cutting $1 in Expenses You Increase Your Profit Immediately

$17 gross profit (17%)

-14 in expenses and overhead (14%)

$3 in profit (3%)

Simple Profit and Loss Statement for Increasing Sales Example

Sales

-Cost of goods sold

Gross profit

-Expenses

Net profit

$101.00 in sales (100%)

-$83.83 in cost of goods sold (83%)*

$17.17 in gross profit (17%)

*Until you manage to decrease your cost of goods sold, your cost remain constant at 83% so if sales increase, your costs increase.

$17.17 gross profit (17%)

-15.00 in expenses and overhead (14.85%)

$2.17 in profit (2.15%)

Notice that by cutting your expenses by $1, your profit increased $1. By increasing sales by $1, using the figures in this example, your profit increased $0.17.

Reason $1 in Sales Doesn't Increase Profit by $1

The reason that increasing sales by $1 doesn't increase profits by $1 is that for every increase in sales, you have a corresponding increase in your costs, such as the labor to produce the product and the materials needed to manufacturer it. If your business is retail, then you have to purchase the products you sell and pay for labor to order, receive, inventory, sell, pull from inventory and deliver.

Obviously there is a finite limit to how much you can reduce your overhead and stay in business. But until you get to that point, cutting expenses has the fastest impact on your profit.

Over the long haul, you will need to increase your sales to grow your business. More sales will spread out your expenses or overhead making them a smaller percentage of your P&L. More importantly, it results in increasing your profits. But when you need to increase profit the fastest, cut your expenses.

*Note: This was written by a Yahoo! contributor. Do you have a story that you'd like to share? Sign up with the Yahoo! Contributor Network to start publishing your own finance articles.

More from this contributor:

First Person: The Value of Small Business Systems

First Person: Controlling Unnecessary Labor Costs

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