There are three critical aspects of business management. They are the reasons why a few small businesses thrive year after year, others languish almost incessantly, while most go from periods of success to periods of struggle.
Pricing, Profits, and Payments
But first, let’s touch on value – your value… as an employee, as a team, as a company. Communicating your value is paramount to everything we’re talking about today. How you present yourself and your business greatly influences your clients’ respect for you and serves to validate your pricing, your profits, and your payments.
Pricing
Let’s look at how some businesses successfully price their goods and services, while others manage to practically price themselves out of business. There are a million ways to get it wrong, and only a few to get it right!
The sad truth about poor pricing is that it doesn’t usually take you out of the game. If your prices are too high, you get enough work to survive but never thrive. If your prices are too low, you get so much work, you’re always busy — too busy to make any real money. You’ll become an expert firefighter by putting out customer fires, employee fires, vendor fires, and so on; however, when you get to the end of the year, you’ll find out you didn’t make as much money as you should, and you might find yourself feeling burnt out too.
About this time of the year, your accounting firm shows up to confirm it. They not only confirm your internal financials, but they also report on things like working capital, return on assets, return on equity, tangible net worth, debt to equity, and cash flow from operations. You gain a tactile understanding of these vital statistics, but then the fire alarm rings. It’ll be a year until your next annual exam. Maybe things will be better next year.
Rule #1 – Your competitor’s pricing should establish a range in which to price your goods and services.
On the pricing spectrum, very few companies set their prices so high that they limit their wealth. By far, most companies end up on the other side: setting their prices too low that they leave money on the table every day, never really creating much wealth for the business.
Rule #2 – Your pricing must scale with the perceived quality of your products or services.
In the eyes of potential clients or prospects, what is the value of your product or service? This is where your pricing model and perceived value must correspond.
RULE #3 - Pricing should always be a function of supply and demand.
It’s basic economics! Your pricing should be a function of your supply and your demand.
Profits
Operations personnel hate it when I say it, but it’s true. In project-based businesses, money is made at the bidding table. Why? Among other things, you cannot project manage your way out of a bad bid.
Gross profits are derived from a simple formula: your price minus your cost to deliver that for which the customer is paying.
We onboarded a new client in 2021 who appeared to be making exceptional margins; but not really making any money. One year would be good, the next year would be bad. As we investigated cumulative earnings over a three-to-five-year period, this seven million-a-year business had earned less than a $100,000 of pre-tax income. Whether $21 million in three years or $35 million over five, it’s a pitiful outcome for the risk and effort.
Revenue volume seemed good for a 35-employee company. So, we talked about pricing in our second and third meetings we had. As we took a closer look at the cost of sales, here’s what we found. This on-site equipment repair company included materials and subcontractor costs. I sat with the three owners and asked who performs all of these repairs. The answer back was, “our employees.” Why on Earth would you not include the cost of your employees in cost of sales? Here’s a company that has been in business for 14 years, and I was the first outside accounting firm to point out this major accounting oversight!
Why is knowing your costs so darn important?
Rule #4 – Your profit calculations should account for all applicable costs of delivering goods or services.
Know your costs – your real costs! This includes labor costs, too.
Rule #5 – Track your profits by both customer (type) and product / service line.
If you’re a labor-based business, you must know your average cost per labor hour. You’ll also want to know your sales / revenues per labor. This is true for nearly every service industry.
It’s even true in the equipment industry. Any good equipment-based business knows its machine hours in production. From this data, we can determine both variable and total costs per machine hour. We can also calculate revenue per machine hour. A simple utilization metric, and we’re off to the races when calculating profit margins.
RULE #6 - Determine the most meaningful utilization metrics for your profitability. Measure and report your profit based on productive assets.
So, much of what we do to serve our customers and employers hangs on timely remuneration. And yet, many small businesses seem to struggle with the basics of getting paid.
Payments
We have another client who encountered a significant cash crisis in the fourth quarter of last year. Earlier in 2022, we helped them secure a $500 tax credit and a $500 mm credit facility. As much as we sought to prepare them for unexpected fluctuations in receipts, this one caught me by surprise.
In this firm, the client billing activities had been relegated to an otherwise dependable employee on the bottom rung of the company hierarchy. Whatever the reasons, she had grown lax in her approach to billing clients for completed work.
When faced with cash flow concerns, start with a look at your billings (customer invoicing). Implement enough checks and balances to ensure timely and accurate clients. Put simply: if you don’t send the bill, you’ll never get paid.
RULE #7 - Bill early, bill often, and bill in full.
Many small businesses struggle to invoice for their products and services. After 25 years in the industry, many modern construction firms with updated technology still use arcane practices to bill their clients. In some respects, we can thank the lawyers for writing contracts which condition payments on a wide range of factors. Even still, such contract terms are a condition of payment, not a condition of billing.
As a financial manager or business owner in any industry, cash flow is a number one priority. Cash flow starts with timely, accurate, and complete billings. So, I’ve adopted this adage over the years: with every client deliverable comes a bill (partial or otherwise).
Even those who have streamlined and/or automated their billing activities can run afoul of lousy payment terms. What advantage do you gain by extending credit to your customers?
When I joined an underwater construction company in 2014, I had oversight of accounting, finance, risk, and legal. The company operated as a contractor. As such, they found themselves conforming to arcane payment terms and contract language.
Having oversight on contract negotiations, I couldn’t for the life of me understand how retention served anyone’s best interest. Yet, this little dive company was agreeing to have retention withheld from nearly every contract. For those unfamiliar, retention holds back 5-10% of a contract amount upon satisfactory completion of a project. They would often wait months, if not years, for other contractors to complete their work before retention would be released. So, we began to push back on retention terms and conditions. Not surprisingly, attorneys for our client were hard-pressed to come up with meaningful arguments on why retentions should be withheld. We were successful in removing most of the retention requirements and significantly improved the availability of working capital.
RULE #8 - Negotiate your payment terms and methods at the time of sale.
Rather than put your business at the mercy of customers, negotiate payment terms, which get you paid fast, preferably at or before you deliver your services.
Closing business is a huge priority. Whether you’re selling tangibles or intangibles, you’re looking to close a sale with a new or existing client so everyone walks away from the table with a sense of satisfaction.
If they’re saying yes to your products or services, get payment expectations clearly defined and memorialized. Tell your client what you need, and, when necessary, explain to them why you need it. Cash flow is the lifeblood of your business.
RULE #9 - Shorten your payment terms to accelerate your cash flow.
In the old days, getting paid was a somewhat cumbersome process. When the order is placed, the customer would first issue a purchase order (PO) – many still do. Then, the product (or service) would be provided with a bill of lading. The customer would then receive it against the PO. Any variations in unit price, shipping, or sales tax could delay the receipt. The receipt and PO would be matched to the invoice before payment could be issued. These were all necessary controls to ensure product delivery complied with the terms of the sale.
All these important steps took days or weeks to get a confirmation sent to accounting. When Accounting completed the three-way match: PO, Receipt, and Invoice, they would record the financial obligation, schedule payment, and then issue a check to be mailed by US postal service. This multi-step process gave rise to 30-day terms – not because the customer needed credit. The customer (and vendor) needed time to complete all these steps!
Today, we operate in a completely different world. The purchase order is provided digitally, often using automated procurement systems. The order can be processed in minutes, the shipping happens in a day or less, receipts are matched and inventories using tagging software, and the invoice is matched shortly thereafter. Automated procurement and accounting systems have dramatically shortened this processing time. Bank payment methods, such as ACH, have ushered in a way to pay vendors the same and the next day.
With all of these advances in technology, why in the world would we still offer our clients 30-day terms? Shorten your payment terms to increase your cashflow. If cash is king, then speed is queen.
Communicating your value is critical to everything you do in business. How you present yourself and your business will greatly influence your client’s respect for you and validate your pricing, yielding profits and payments. Our job is to bring value (lots of it) to our customers so their needs are met, they feel empowered to succeed, and they’re eager to show us their money.
Contact us now to set up an initial consultation about your business.
