Understanding major forces of net profit

Managing these components correctly will put your organisation on the path to stronger financial results.

There are certain forces that affect net profit. It is important for a company to understand and control these forces to achieve better financial results.

For many businesses, the five components within their control that most directly affect a company’s profit over the short run are price, cost, inventory, taxation, and cost of capital. To be successful, an organisation needs a strategy for all five.

What follows are some considerations for each of the five areas. The list is not exhaustive; rather it is meant to spark thoughts and discussions.

Price

Price is the most important component of net profit. The pricing strategy chosen to maximise sales and profit will vary from company to company and will depend on their marketing goals, mission, and objectives, but common pricing strategies are cost-plus pricing, competitive pricing, price skimming, penetration pricing, premium pricing, perceived value pricing, and target pricing.

There are many other factors to consider in deciding a correct price, such as the costs of production, distribution, and marketing; competitors’ pricing and activity; perceived value by the customer; government influence; trade requirements; and volume targets.

Prices should be reviewed regularly to ensure that they reflect current cost, market demands, timely response to competitors, and profit objectives. The following can be an aid for determining the right price of a product:

  • Define, communicate, and implement a clear pricing strategy. 
  • Build an accurate cost structure for each product.
  • Clearly identify and control variable costs for a better pricing decision.
  • Calculate net margins of each product. Use different margins for products based on the market, and customers’ responses and demands.
  • Check the price of comparable or alternative products in the market to assess current product prices.
  • Know your competitors’ prices.
  • Use tactical pricing techniques for a short period of time to respond to changing conditions in a market, such as the use of discounts to sell slow-moving stocks or increase market share.

Cost

Cost is another major component of net profit. Increases in the cost of raw materials, wages, factory overhead, and other expenses will decrease net profit. Therefore, costs need to be controlled. The following steps can help to control costs:

  • Develop and implement a cost-control strategy across the company.
  • Benchmark against competitors or other organisations to help in cost control.
  • Involve employees in cost control. Employees can suggest cost-saving ideas, especially if there is an incentive to do so.
  • Customers and suppliers can also help in cost control, if they are involved in the cost-control process.
  • Improve purchasing. Switch to cheaper suppliers or negotiate price reductions or higher discounts for early payment. Agree to long-term supply contracts or guarantee minimum annual purchase volumes in return for lower prices.
  • Reduce payroll costs by outsourcing noncore activities, using consultants, freelancers, or part-time employees, where practical.
  • Find ways to make production more efficient. Increase production runs to reduce the cost per product. Use standard components to lower design, purchasing, and manufacturing costs.
  • Review finance cost. Reduce unnecessary overdrafts and loans.
  • Maintain and improve a quality-control system to manage rejection and reworking costs.
  • Control operating expenses in real time, if possible.

Inventory

Inventory is the third component of net profit. A good inventory management practice includes the following:

  • Develop and implement an inventory control policy across the company. State clearly the company’s policy in relation to storage, maximum level, minimum level, reorder, and safety levels of inventory.
  • Prepare inventory budgets for better control.
  • Maintain proper accounting records for inventory.
  • Decide quantity to be purchased at a time.
  • Inventory turnover should be maintained for each item.
  • Conduct physical stock-taking and compare actual inventory with inventory in books of account on a regular basis.

Taxation

A rise in tax rates has the same effect on net profit as an increase in cost. Tax is a business expense that needs to be managed like any other expense. Tax can have a huge impact on net profit and company reputation if not managed properly. A company needs effective tax planning to pay tax completely, correctly, and economically. Good tax planning includes the following:

  • Establish and implement a clear tax strategy. It will cover good and legal practices leading to reduction and management of tax. It will cover tax risks and a governance framework.
  • Maintain accounting systems and controls sufficient to support tax compliance obligations.
  • Identify and calculate all available tax deductions.
  • Know and pursue the available tax credits on time.
  • Maintain a record of business transactions and receipts that will help to file a timely tax return.
  • Improve transparency on taxation matters. Maintain open and transparent relationships with the tax authorities.
  • Plan cash flows to make timely payment of tax.
  • Pay taxes on time and in accordance with applicable laws and regulations, and comply with relevant tax laws and disclosure obligations.
  • Tax-related documents should be retained for at least the period required by the tax laws.

A company is exposed to different tax risks such as compliance, transactional, and reputational risks. These risks need to be managed on time. Tax managers will generally take the lead role in identifying, managing, and monitoring tax risks. Where appropriate, engage with tax authorities to disclose and resolve issues, risks, and uncertain tax positions.

Cost of capital

The final component of net profit is something that is often out of companies’ control. However, finding the right mix of debt and equity financing is a basic objective of any prudent finance strategy. The optimal capital structure is one that offers a balance between the debts and equity in such a way that minimises the cost of capital, improves profit, and limits the risk of default. 

The optimal capital structure of a company will depend on factors including the following:

  • Size of the company. It can be difficult for small companies to obtain loans. They raise finance through share capital, while large companies enjoy more bank loans.
  • Availability of fixed assets. Banks need security to issue loans. If a company has more fixed assets, it can be used to secure long-term loans.
  • Future cash flow will impact on capital structure. More debt will be used if future cash flow can be relied on to pay interest on time.
  • Cost of debt and equity. More debts will be used if debt cost is less than the cost of capital.
  • Tax rates will impact the decision.
  • Capital structure can be influenced by government regulations. It may be compulsory for companies to maintain a given debt-equity ratio while raising finances from banks.

Managing these five components correctly, through proper control and process, will put your organisation on the path to better financial results.    

Shafi-ur-Rehman, FCMA, CGMA, has worked as a finance manager for the past 22 years, joining Bin Habib Group Dubai as finance manager in August 2004 and subsequently being promoted to general manager in 2008. To comment on this article or to suggest an idea for another article, contact Kim Nilsen, the publisher of FM magazine, at Kim.Nilsen@aicpa-cima.com.