The vast majority of SMEs are profitable businesses with 80% of UK SMEs reporting making a profit in 2020  – but how many of them are maximising their profits?
Profit maximisation is an approach that can enable efficient and sustained business growth. If you’re ready to expand your business, employing a profit maximisation strategy will ensure that increased effort leads to increased net revenue.
What is profit maximisation?
In economics, the "law of diminishing marginal returns" states that there’s a point in the production cycle where the cost of producing an additional unit diminishes the marginal returns that you’ll receive from it.
"Profit maximisation" highlights where that point is – the optimum output at which your business is most profitable. According to the Khan Academy, a non-profit educational organisation: “a firm trying to maximise profit will produce the quantity where ‘marginal cost’ and ‘marginal revenue’ are equal to each other.”
Example of profit maximisation
Assume a shop owner is toying with the idea of keeping their shop open for an extra hour every day. The critical question for them to consider is: will the additional business hour cost less than the additional revenue generated by it?
If so, it’s financially prudent for the shop to remain open for an extra hour but, if not, the extra hour is costing the shop owner – even if they’re still making a gross profit.
Profit is maximised when marginal revenue (i.e. the additional revenue the shop generates for opening an extra hour) is equal to marginal cost (i.e. the additional cost the shop incurs for opening an extra hour).
Advantages of profit maximisation
Profit maximisation has a host of benefits including:
Improving long-term cash flow
Adopting a profit maximisation approach is a good way to keep your operating cash flow healthy. Operating cash flow (also known as Cash Flows from Operations, or CFO) is the amount of cash that a business generates from its core operations, minus the cost of running those operations.
A business that ensures the marginal cost never exceeds the marginal revenue is primed to generate positive cash flows. This in turn creates value for shareholders and presents an attractive proposition for investors.
Strategic business growth
When it comes to strategic business growth, timing is everything.
While it’s important to take your business to the next level, it’s equally important to know when to do so. It’s natural for small business owners to want to increase production quickly – often ahead of schedule. But the pitfalls of this approach include:
- Too many outlets opening too fast and not being sustainable
- Cash being tied up in inventory that won’t sell
- Employees working hours that don’t turn a profit
Profit maximisation can help business owners avoid these scenarios and ensure your decision-making is guided by figures – not faith or fear.
Lean business operations
A lean business machine is often an efficient one.
Andrew Elliot, CEO and founder of the London Consulting Group, says profit maximisation “cuts out the fat” and “converts it into muscle by improving throughput velocity and gaining better control of productivity, service levels and results.”
Disadvantages of profit maximisation
There are a few potential pitfalls when it comes to profit maximisation:
Damaged brand reputation
Consumers may perceive companies engaging in profit maximisation as being wholly motivated by profit, which can damage brand perception. Today’s consumer seeks out companies whose values align with their own , so it’s important to communicate your brand purpose, whilst maintaining a focus on increasing profits.
Profit maximisation can spell bad news for customers if a company supplies inferior products in order to maximise profits. While lowering the production costs will increase your gross profit in the short term, your customers will notice any decline in quality, which could ultimately drive them away.
Similarly, customers may feel they have been handed a raw deal if a company hikes its prices to maximise profits.
5 tips on how to maximise your profits
To achieve profit maximisation, your business can increase revenue, decrease costs or both.
1. Run promotional campaigns to introduce your customer base to new products
2. Review your product line and conduct a competitor analysis to ascertain whether customers consider your price point to be good value.
This doesn't always mean lowering prices. In order to ensure family-run mochi ice cream company Little Moons keep its loyal customers coming back for more, Co Founder Vivian Wong says: “We often choose to use more expensive, better quality ingredients resulting in better-tasting products despite a direct hit to our bottom line."
3. Engage your employees for improved productivity
“We’ve always prioritised our people’s wellbeing,” says Wong. “How they feel and their engagement are top of our list, so we’ve always ensured that improvements don’t adversely impact them, their working practices and environment.”
“Today, the only businesses that will succeed are the ones that balance profit maximisation with caring for employees, clients, suppliers and other stakeholders,” says Ozana Giusca, a business adviser to SMEs. “Nowadays, the profit equation is not revenue minus costs. It’s ‘win-win’ – a balance between all stakeholders.”
4. Reduce overheads by analysing where money is being spent and where it can be saved, in order to maximise your operating profit. “To make the right decisions, you must have a clear picture of your costs structure and where value is generated and lost,” says Elliot.
“When we started our business, we decided to manufacture our products,” says Wong. “While this resulted in increased capital outlay, it’s meant that we’ve benefitted from economies of scale as we’ve grown as well as improved efficiencies through learning and process improvements.”
5. Adopt time-saving and production-enhancing technology.
“Digital transformation is part of the solution, but it’s not the complete solution,” says Elliot. “Change has to be synchronised: improve workflows, incorporate technology and train staff. If you work these three angles, improved profits will trickle in by themselves.”
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