We often underscore the importance of financial management in your personal finances. We also underscore the same for your business finances. Financial literacy, especially nowadays, is imperative. The essential ability to figure out if you are making profits or losses is borne out of financial literacy. Profit, though is influenced by numerous pertinent variables. At times it is difficult for many in business to factor in all of them. Nonetheless, it is businesses that appreciate and exercise financial prudence that excel. As is the case with all things numbers, formulas (or formulae) come into play. Today you will learn a practical, interesting 5-point profit growth formula.

5 Fundamental Variables Behind Net Profit

Let us break down some definitions of key terms here. First off, net profit is the amount by which income from sales is more significant than all expenditures. In short, it is gross revenue minus all expenses. The desired endpoint in all business endeavours is a net profit (not a net loss). How do you get there, though?

It starts off with leads; that is when it starts getting serious. A lead is a potential customer – a prospect. That lead must result in a conversion. A conversion is a metric that denotes someone having done what was intended for them to do. Conversion is commonly a sale or purchase, i.e. when someone buys a product or service. Then we have gross profit. Gross profit or gross profit margin is the difference between revenue (i.e. net sales) and the cost of producing goods or services sold. Typically gross profit margin is expressed as a percentage.

The summary here is the key to understanding the formula we are looking at today. You start off with leads. Those leads have to result in conversions (purchases). Ideally, those conversions must be sustained and even increased (frequency or size). Essentially the conversion rate must be high. Then when all is said and done, we get to net profit. Thus the 5 points to note are:

Leads (L)

Conversion Rate (CR) – leads who buy out of the total leads as a percentage.

Number of Purchases (NP) – average count of a customer’s purchases annually

Average amount per purchase (AP)

Gross Profit margin (GM)

Let us get into what the actual 5-point profit growth formula is.

Breaking Down The 5-Point Profit Growth Formula

NB: Several more variables will come into the mix: current retained customers (RC) and overhead costs (OC). The other variables are total customers acquired (CA) and total customers (TC). Total revenue (TR) and gross profit (GP) exist. Of course, you will notice that some variables depend on other variables. So as you know, the formula involves a series of steps. Here is the formula:

Step 1: L × CR = CA

Step 2: CA + RC = TC

Step 3: TC × NP × AP = TR

Step 4: TR × GM = GP

Step 5: GP – OC = Net Profit

In essence, Leads (L), Conversion Rate (CR), Number of Purchases (NP), Average amount per purchase (AP), and Gross Profit Margin (GM) are the variables you have to keep an eye on. They are variables that you can figure out how to influence. You have to tweak them to achieve certain net profit goals you might have in mind. No wonder it is a 5-point profit growth formula. Let us assume an example so that you get the drift:

You generate 250 leads within one year. 30 percent of them became actual customers. Let us suppose you already have (or had) 200 customers. On average a customer purchases 3 times annually. Let us say the average amount they spend whenever they buy is US$25. Let us assume your gross profit margin is 40 percent. Maybe your overhead costs totalled US$10000. Let us apply the 5-point profit growth formula:

Step 1: 250 × 0.3 = 75

Step 2: 75 + 200 = 275

Step 3: 275 × 3 × 25 = 20625

Step 4: 20625 × 0.4 = 8250

Step 5: 8250 – 10000 = -1750 (Meaning you made a net loss of US$1750)

The figures or variables in bold there are the ones you can tweak to get to the net profit you desire. In this case, you can work on increasing your conversion rate. You can also work towards increasing the number of repeat purchases per customer. Additionally, you can also figure out ways to make them spend more per purchase.

Another critical area is that of gross profit margin. You could find ways to widen the margin (in the positive), closely tied to reducing overhead costs. Thus you can see this formula is excellent at forecasting for planning purposes. You can play around with scenarios to see how they end up. The 5-point profit growth formula is a valuable tool in business strategy formulation.

It might seem complex at first glance, but it is quite simple and easy to understand. Start putting this 5-point profit growth formula to use in your business. It is effective in working out your what-if scenarios. Remember, you can never achieve what you did not deliberately plan in the first place. Financial planning is non-negotiable in any business venture.