Why Margin Compression Could Be Silently Killing Your Business & What To Do About It
“Risk comes from not knowing what you are doing.” - Warren Buffet
Business owners are used to taking risks. It’s part of your DNA. You regularly make calculated decisions on large investments and sometimes take leaps forward into the ‘unknown’ on an ongoing basis to continue your upward growth.
Calculated risks are essential and over time you become familiar with the process.
There is one risk that many business owners are taking right now that is not calculated and not going to pay off well in the end. That is the risk of not paying attention to the current economic storm that is brewing. ‘Sleep walking’ is how some leaders are describing it right now. Putting your head in the sand and hoping it will all work out in the end. However, margin compression, if unattended to, could silently kill your business.
We work with clients who are focussed on creating success on purpose. Being proactive is a big part of this, and right now the discussion we are continually having is around this concept of margin compression. To continue in an upward trajectory over the next 2 years, you will need to be paying close attention to how this is affecting your business and quickly responding when you need to.
So what is margin compression?
In short, it is when your input costs rise faster than the sale price of your product or service. This leads to declining margins over time.
This doesn’t happen overnight - you won’t wake up one morning and suddenly have your margins are eroded. No, this happens slowly and so many business owners don’t realise it is happening until it has dramatically affected profits and the health of the business.
Why is this important right now?
There are a few external factors that are affecting profit margins right now in Australia.
Rising costs - The consumer price index rose 5.1% in the last 12 months which is the worst result we have seen in over 20 years.
The cost of housing has increased by 4.7% this quarter and has risen by 23.7% over the last 12 months according to ABS ( Weighted average of the eight capital cities)
Fuel prices are at an eight-year high which has a knock on effect with transportation costs, freight, and manufacturing.
Interest rates continue to increase with another 5 rate-hikes predicted for this year alone. Read our latest update on interest rates here.
Continue shortages of skilled workers is putting more pressure on business owners to increase wages and is slowing supply chains (which also contributes to price increases)
How to Manage Margin Compression?
Don’t be complacent. Many business owners still don’t understand the basics of economics in their businesses. You need to have a strong fundamental understanding of the unit economics in your business. Understand where the price increases are happening and where you can lock in fixed costs to bring about some economic stability.
Don’t fall into the revenue trap thinking that this will solve your margin problems. Growth solves many problems in business, unit economics is not one of them.
Here are 8 steps you can implement in your business today,to ensure you proactively manage your margin compression:
Identify your monthly fixed costs - If you closed your doors tomorrow and didn’t sell a thing, which costs would still exist. Things like rent and utilities, telephone and probably some wage costs (these will vary for every business). Exclude non-cash costs such as Depreciation and Amortisation and also capital costs such as Interest
Understand your monthly variable costs. These are the rest. If you can further allocate these to various services or product lines, you should do so. They may vary significantly across different revenue streams.
Know your actual Gross Margin. This is the difference between your product revenue and your variable costs. Express this as a % and will tell you that for every $1 that comes into your business, how many cents in the dollar are left to pay overheads
Work out your breakeven for your business - take your fixed costs from step 1 and divide by your Gross Margin % at Step 3. This will tell you the minimum monthly revenue your business needs to generate to break even
Work out your Operating Profit margin or EBITDA margin, again as a %. Review your historical performance of your business - compare various periods like last month versus the same month last year, last quarter versus same quarter last year (or go back 2 years if COVID results are skewing the data)
Benchmark yourself to your industry. You should be making at least 10% EBITDA. If you are a service based business, you should be making at least 30% EBITDA, before deducting any salaries for equity owners
Compare your existing pricing and margin assumptions to your ACTUAL historical performance. You might be surprised at what you find. Almost every business we have worked with, that actually had any idea of what their margin even was, gave us assumptions that were significantly different to their actual historical performance. Know your actuals and adjust your quoting and pricing assumptions where you need to.
Implement a formal monthly review of each of these areas in your business by establishing an advisory board structure that can hold the business to account.
This is not an exhaustive list of everything you ever need to keep an eye on in your business, but these are some simple actionable steps you can implement in your business today.
What can I do if my Unit Economics are sub-par?
Review your pricing. Once you have understood your current and potential rise in costs, take action and increase the price of your own products or services and communicate clearly with your customers. Work out a price increase that you are comfortable with, and raise your prices by more. Be uncomfortable with your price increases and be prepared to lose some business as a result. If you are only raising prices by around 5%, your unit economics and margins will already have eroded given inflation is at 5.1%
Review your customers - all of us put up with bad or unprofitable customers in the ‘hope’ that things will change. Hope is NOT a strategy you should rely on in the coming 12 months (or ever really).
Look for opportunities - everyone is doing it tough and not everyone will survive. Be patient and proactively identify strong opportunities for new product lines, customer acquisition opportunities, service models, partnerships and potential M&A.
Don’t chase revenue at all costs. I know it’s tempting - business owners love nothing more than more customers and more revenue. BE CAREFUL! Not all revenue is created equal
Lock in cost pricing. Talk to suppliers and see where you can lock in prices or order now to cover supply needs in the future.
Don’t stick your head in the sand - there are some testing times ahead but there are also plenty of opportunities. Do something about this, put structures in place in your business. What you have done in the past will not get you to where you need to be in the future. Get help if you need it. Make sure you know what you need to know and have triggers and plans in place so that you’re not making it up on the run.
We are here to help. Join us for our upcoming webinar: “How to Survice the Economic Storm that is Brewing.” You can register HERE.
