We talk about the importance of understanding, increasing and unlocking the value of a business and while much of what we write and teach about relates to understanding how business valuation works, here we are focusing on increasing the value of a business.
While there are many quantitative and qualitative levers that impact the value of a business, in our nearly 50 years of valuing privately held businesses we have found that the most impactful way to increase value is to first focus on increasing a company’s gross profit. Gross profit is reported on the Income Statement (or Profit & Loss Statement) of businesses and is calculated by taking sales minus the direct expenses that are directly tied to that sale. These expenses are often referred to as ‘cost of goods sold.’
For example, if the company is a manufacturer of products, in order to make a sale of one manufactured part, the company needs to pay for the raw material, labor and the freight to deliver that manufactured part. Alternatively, a service-based business may not track ‘cost of goods sold,’ but instead would calculate gross profit by subtracting the direct expenses, such as labor, from sales. In both situations, it is the expense that must be incurred to generate a dollar of sales. Gross profit is the amount of sales left over after paying for these direct expenses and represents the profit available for paying the company’s overhead expenses and making a profit.
A Case Study: How Important is Gross Profit to Value?
One year ago we began working with a business owner who intended to begin preparing to transition ownership in the next 3-5 years. We began by valuing the business as of December 31, 2021 and the conclusion of value was $1,184,000. Based on the owner’s retirement plans, this value was significantly lower than the amount needed to retire.
We often say the process of business valuation provides far more information than just the value conclusion to the business owner. Our process helped the owner and the leadership team understand and prioritize the factors to work on in order to increase value. As mentioned, we encouraged them to first focus on increasing gross profit margins because even a 1% increase in gross profit can have a significant impact on value.
Here are the levers a business owner has to increase gross profit which we discussed with our client:
- Increase selling price or rates--this does not mean sell more, but rather charge more for what you are selling.
- Negotiate lower purchase prices--or increased discount(s)--on parts/raw material. Don’t forget that as the company grows, purchase of raw materials increases. This increase can translate into increased buying power. Can this buying power be leveraged for better pricing?
- Decrease fixed labor costs by tying a portion of the labor expense to productivity and/or profitability. This can be paid in the form of bonuses rather than fixed salaries or standard hourly compensation.
- Negotiate shifting some or all of the shipping costs to the supplier or make this expense a pass through to the customer.
One year later, after successfully negotiating lower purchase prices, our client increased the company’s gross profit margin (gross profit dollars divided by total sales dollars) by 1%, and had the business valued again as of December 31, 2022. The value of the business had increased from $1,184,000 to $1,876,000. In this client's case, a 1% increase in gross profit margin resulted in a 37% ($692,000) increase in business value. While this increase in just one year may not be possible for every business situation, it illustrates the power of focusing the leadership team’s efforts on the most impactful levers first (i.e. gross profit), before moving to other initiatives that can also increase value, but not as dramatically.
So, while it may seem intuitive when thinking about increasing value to go to work on increasing sales or reducing the operating expenses, in fact, it actually is best to prioritize increasing your gross profits. Simply stated, an improvement in your gross profit is multiplicative to value. THEN go about working on other areas of the business. As a reminder, we wrote a blog on additional ways to increase value that you can find here.
If you would like to discuss a specific business situation please reach out to us through the Contact page or call us at 608-257-2757 and we’ll connect you to a business valuation expert on our team.