Peddling hard on the cash cycle
Thursday, March 8, 2007/
Sometimes you can make more money by cutting your charges. How does that work? Let’s do the maths.
I had an interesting experience the other day. A guy told me he was sure his competitors would go out of business.
“How come?” I asked. “Well, you see, I have a gross 50% mark up on my product and my competitors have cut their price to the bone. They can’t make a profit at the prices they are charging. They will go broke”.
As it happened, I knew something about the industry and so I asked this guy whether he had done any financial analysis. “What do you mean?” he asked. “Well, for instance, have you looked at your turnover? How long is it taking you to turn over your stock?”
He didn’t know off hand but he could soon find out. A week later he came around and told me that he was turning over his stock three times a year. I said: “In that case, you might be the one who will go out of business rather than your competitors.”
He looked shocked, so we sat down and did some numbers. He told me his competitors’ prices were 20–30% below his. I asked what would happen if he reduced his price by 30%. “Don’t be silly. My fixed costs are 25% of the cost of the product, which means that if I reduce my gross margin from 50% to 20% I am making a loss. That’s why my competitors will go out of business.”
I suggested I didn’t know how quickly his competitors were turning over stock but I suspected that it had to be a better turnover than my friend because the price was so much more competitive.
I said: “Let’s assume that your competitors are turning over stock twice as fast as you because of the fact that their price is cheaper than yours (in fact, they were turning stock over 12 times a year). If they halve their margins and double their stock turn, they can make the same profit as you do with a 50% margin, and as they take more and more customers away from you, they can reduce their margins even further through increased sales and higher turnover.
He didn’t get it and so I reduced it to mathematics.
You have $1000 and either buy or produce stock with that money. You add 50% margin so the selling price is $1500 and you sell the product three times a year. Your fixed costs are, say, $2 a day. Over 360 days it costs you $720 to produce your stock and you get $1500 gross profit, leaving $780 profit.
Your competitor reduces his margin to 20% and has the same fixed costs as you of $2 a day. Because the price is much more competitive, stock is turned over every month. This means that with the same fixed costs, the gross profit at the end of the year is 12 times $200 (being 20% mark up) and that amounts to $2400. After deducting fixed costs of $720, your competitor is making a profit of $1680 a year.
It’s called the “cash business cycle” and what the cash business cycle says is “the quicker you can turn over your stock, provided you keep your costs under control, the more profit you make. One way to accelerate sales is to have a competitive product selling at a much better price than your competitor”.
So sometimes, when we think that our competitor doesn’t know what they are doing, it just might be that they are quite smart and laughing all the way to the bank. They might just understand the cash business cycle better than everyone else.
Louis Coutts left law and became a successful entrepreneur. His blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Click here to find out more.