How to Grow a Company into Bankruptcy! (Part 2)
06 Jan 2020
Cary Selby, CPA, CA - Managing Partner
In part 1 of this blog, we discussed a real-life situation that our firm had encountered with a client whose sole focus was on growing sales. The client cut prices significantly, however, the price cuts were not offset by reductions in product costs, and also resulted in significant increases in overhead expenses. Within three years, a once highly profitable business was forced into bankruptcy.
There are a number of important lessons to be learned from this situation, so that you, as a business owner, will not fall victim to a similar situation:
- Increased sales do not necessarily mean the business is "doing well". Ultimately, the crucial factor is the gross profit generated by those additional sales, and whether the gross profit is sufficient to cover all overhead expenses, while leaving a net profit. A common tool we use to determine the impact of a change in selling price is a "sensitivity analysis" - i.e. if I raise prices by 5%, what percentage of customers would I have to retain to make this a profitable move? Conversely, if I reduce prices by 5%, how many new sales do I need to make up for the reduction in gross profit?
- When making significant changes in pricing policy, the impact to the bottom line is not just the change in gross profit, but also how the change will impact overall selling and administrative expenses. In the situation discussed, the price reductions resulted in a large increase in sales, and thereafter a large increase in other overhead expenses.
- If you are paying a professional accountant to advise you, carefully consider the advice you receive. An experienced accountant will have the knowledge of working with many businesses in various industries and would be able to provide valuable insight into what you are proposing. While the final decision is always that of the business owner, it is important to take advantage of the expertise available to you.
There seem to be many businesses with tremendous sales and growth which are still unable to earn a good profit. In the long run, if a business cannot earn a profit, it will no longer stay in business, as investors will stop pouring money into a money pit!