Did you know you can use the power of compounding to grow your profits, reduce cash flow issues and improve upon the performance of your business?
Albert Einstein once said: “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it.”
We understand the positive impact of compound interest.
We save money, interest is added and over time we earn more interest on not only the amount we save, but on top of the interest we’ve earned already.
In equal measure, we also understand that it can work against us.
On credit card balances that remain unpaid, the outstanding debt gets larger as interest charges are added.
But what about other aspects of compounding that apply more widely within a business? Read this article on the power of compounding to discover the three simple steps that can help you:
- Add value both to your business and your customers
- Understand value discipline across pricing, cost of sales, and dealing with debtors and creditors
- Make changes at the right time to keep your business moving in the right direction.
Here’s what we cover:
- The potential for positive compounding
- The risk of negative compounding
- Put value before volume
- Maintain value discipline
- Course correct but stay the course
- Final thoughts on the power of compounding for your business
The potential for positive compounding
A well-managed business looks to grow its profits, some of which are distributed to its owners and some retained within the business. Here, we see the potential for positive compounding:
1. Borrowing less
The more retained profit a business has, the less it needs to borrow to fund its operations.
This results in less borrowing, which results in lower interest charges and other costs connected with lending, resulting in more profit retained.
2. Reduction in cash flow issues
Increased retained profit funds working capital and reduces the likelihood and severity of cash flow issues.
This enables the business to be more efficient and further increase profit retained.
3. Safety net for unexpected events
Increased retained profit and reserves within the business provide a safety net for the business to deal with unexpected events or downturns in the economy.
During economic downturns, businesses that are financially sound can often capitalise on opportunities and cheaper prices to increase retained profit further.
4. Increase in performance and returns
Business performance and returns are significantly increased over time.
Not from specific sales initiatives or strategic decisions but simply by running the business efficiently and creating the conditions for positive compounding to thrive.
The risk of negative compounding
As with so many “wonders”, when it comes to the power of compounding, the potential for gain is matched by potential for loss.
Consider the business that is focused on driving sales volume. The following negative compounding can occur:
- Discounts are given as people think that lower prices will drive higher sales. Unfortunately, this does not drive sales increases but reduces profit, which puts additional stress on cash flow as there is reduced margin for error.
- In further attempts to drive sales volume, the business lets debtor balances increase by selling to customers who already have overdue accounts. This compounds cash flow issues further as customers take longer to pay invoices.
- Orders need to be fulfilled quickly, resulting in reduced purchasing discipline in price and quantity. The company buys in without regard to price so orders can be delivered and invoiced more quickly. This results in the payment of higher material prices and an increase in stock, which puts further pressure on cash flow.
- Once this negative compounding takes hold, the first attempts to improve cash flow involve delaying payments to creditors. Creditors accept this for a short time but then start to refuse to supply goods. Once this happens, and if overdraft and other funding sources are exhausted, the business fails.
The above scenario is created by actions and events that are within the control of the business. The focus on sales and sales volume provides a rich environment for negative compounding to take hold.
But it doesn’t have to be like this.
So, how can you harness the power of the eighth wonder of the world to reap the benefits of compounding returns and avoid the damage of compounding costs?
It takes three simple steps:
- Put value before volume
- Maintain value discipline
- Course correct but stay the course.
Put value before volume
Every successful business creates and delivers amazing value for its customers.
But what sometimes gets forgotten is that this must be done in a way that also delivers value back to the business.
There must be a fair and equitable value exchange.
Being obsessed with driving value involves not only doing so for the customer but also reciprocating it for the business through profit and cash flow.
To do this, you need to look at the following areas:
Product/service mix: What is the right combination of products and services to provide the optimal profit when delivered at the right price and margin?
- What are the top products and services you sell by volume?
- What are the top products and services you sell by profit?
- What are the products make the biggest contribution to overall profit?
As a result of these insights:
- What are the products and services you should focus on?
- What are the products and services to maintain?
- What re the products and services to discontinue?
Customer mix: It’s important to remember that not all customers are created equal. The one we think is our biggest, most important customer could actually be our least profitable.
Profit has to be the yardstick by which we judge the importance of our customers.
Who are the customers who buy sufficient volume at the right price and margin, and who pay on time to provide optimal profit and cash flow?
Questions to ask include:
- Who are your biggest customers by sales volume?
- Who are your biggest customers by profit?
- Which customers make the biggest contribution to overall profit?
- Which customers pay on time?
As a result of these insights:
- Who are your premium customers, on whom you should concentrate your efforts based on high profit and fast payments?
- Who are your core customers that should be maintained and improved (by improving the product mix they buy, for example) based on good profit and average payment speed?
- Who are your drop customers, which should be discontinued on the basis of low profit and slow payments? Here, you can either stop supplying them or increase prices and chase payment harder, which could convert them into a core customer.
When stopping supplying customers who aren’t profitable or don’t pay, remember that:
- They are damaging your business
- They are likely to go and cause problems for your competition.
The customer mix insight will also enable you to assess the most effective channels for your business.
Channel optimisation: What are the most efficient and profitable ways of delivering products and services to customers?
- What are the channels that serve your most profitable customers?
- What channels deliver the most revenue?
- What channels deliver the most profit?
- Which channels cost the most?
As a result of this insight:
- What are your highest performing channels based on revenue and profit?
- How could the channels that service your most profitable customers be used to reach similar customers?
- Which channels are not effective and need to be reviewed?
Pricing and gross margin: This is the most important and effective strategy for delivering value to your business.
Businesses inadvertently reduce profitability though discounts and their reluctance to increase prices for the fear of losing price-sensitive customers.
- Are the prices you are charging achieving the overall gross margin you need to achieve?
- When setting prices, have you considered all the additional costs of sales and overheads?
- When was the last time you increased your prices?
- Do you have a discount policy and is it enforced consistently?
As a result of this insight:
- Are there products and services that need to be increased in price to achieve minimum profit?
- Using your product mix insight, are there profitable products where prices could be increased further due to their position in the market?
- What discounting and pricing policy do you need to create and enforce?
A sobering thought on discounting and a reassuring one on price increases
A business with a gross profit margin of 30% that gives a discount of 10% must increase sales by 40% in order to just maintain the same level of gross profit. That’s a 40% increase in sales just to stand still.
Do you still think discounting works?
The same business with 30% gross margin on a 2% increase in price sales would have to drop a whole 6% before gross profit was affected.
Maintain value discipline
Once you have optimised value within the business, the next step is to maintain value discipline to drive positive compounding while mitigating negative compounding.
Maintaining value discipline over time not only delivers positive ‘financial’ compounding but also positive ‘behavioural’ compounding in the actions of people within the business, maintaining value becomes a habit.
This behaviour will drive further positive financial compounding.
Here are four key areas to practice value discipline (you can use your accounting software to track them):
Do not discount, as you are simply giving away your profit.
If you must discount then ensure you have clear discounting policies in place that allow you to achieve the required return and stick to them.
Discounting is one of the biggest causes of negative compounding within a business.
Prices should be increased regularly in small amounts according to the category of customer and at least cover the rate of inflation and increases in costs and materials.
Cost of sales
Proactively managing cost of sales ensures that profit is being maximised on every single sale made by the business.
A single 1% improvement can make a significant difference over time.
Chase debtors promptly and stop supplying customers who have overdue accounts. Prioritise those customers who pay on time to increase cash flow.
This alone will significantly reduce the company’s working capital need and subsequent borrowing costs.
Prompt payment of creditors develops better long-term relationships with suppliers.
This could lead to not only lower cost of sales through better prices, which increases profit margins, but also faster delivery times, therefore reducing stock to free up cash and reduces the working capital need.
When driving value, it’s worth remembering “turnover is vanity, profit is sanity and cash is king” to ensure you always focus on the areas of the business that generate the most profit and cash flow.
Course correct but stay the course
To gain maximum benefit from compounding, time plays a significant role. Time allows the compounding to take effect and generate returns.
All too often, changes are made prematurely because of a perception that a course of action is not working when actually all that was needed was more time.
Due to changing market or economic conditions, risks of negative compounding might emerge. This might require you to adjust your value focus and strategy.
Typically, there are a number of areas you need to keep under constant review:
Pricing and cost of sales
These are areas where negative compounding can emerge quickly, so small, regular and category-focused price increases should be part of your standard operating procedures.
Cost of sales can gradually creep up either as suppliers increase prices, or discipline around purchasing weakens.
They need to be monitored and reviewed. Premium customers might become core customers and vice versa. Core customers might move to drop customers.
Focusing your efforts on developing your premium customers into key promoters of your business, developing your core customers into premium customers and offloading your drop customers is an ongoing process.
These will emerge as you build a solid value foundation and positive compounding begins to gather momentum.
This gives you the opportunity to scale up; do this while maintaining value discipline and positive compounding will also scale.
All of this represents course corrections – small tweaks to optimise positive compounding as your business continues to evolve.
The work completed on value focus and value discipline should give you the evidence and confidence to maintain your course.
Final thoughts on the power of compounding for your business
The key to managing a successful and sustainable business can be summarised in the words of the legendary investment manager Jack Bogle, founder of Vanguard.
Your job is “to prevent the tyranny of compounding costs to overwhelm the magic of compounding returns for your business”.
Do this and you will truly harness the power of compounding and achieve your goals faster than you ever thought possible.
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