Raising profit margins in a stagnant economy - Advice to SME owners

Jeremy Lang

South Africa’s current economic environment poses a real risk for small and medium enterprise (SME) owners given its stagnant growth, and it is increasingly more difficult for local businesses to sustain themselves, let alone increase profit margins.

This is according to Jeremy Lang, regional general manager at Business Partners Limited (BUSINESS/PARTNERS), who was commenting on the June 2016 Quarterly Financial Statistics (QFS) released by Statistics SA this morning. While turnover increased in all eight industries covered in the survey from R1,99 trillion in the first quarter to R2,08 trillion in the second quarter (+4.5%) – after decreasing by 5.1% in the previous quarter – Lang says that the local environment remains strained for businesses, especially SMEs.

The estimates for small, medium and large enterprises in the June 2016 QFS revealed that while net profits (across all industries, and before taxation) increased quarter-on-quarter for both small (from R33,0 billion to R41,4bn – up 25%) and medium businesses (R11,1bn to R11,5bn – up 3.5%) when compared to the previous quarter, these are less favourable when comparing year-on-year, especially for small businesses.

“Net profit of small businesses have declined by 35% from R64,0bn in June 2015 to R41,4bn in June 2016, while medium and large businesses have reported increases of 11% and 38% respectively during the same period. This highlights how small businesses tend to be more vulnerable to sustained periods of low economic growth and increasing costs, compared to larger businesses who have the financial resources to sustain their operations.”

He adds: “While the economy grew by 3,3% during the second quarter of 2016, resulting in the GDP forecast for the year being revised from zero growth to 0,4%, the Reserve Bank has warned that the economy remains weak. These economic conditions, coupled with the increasing overhead costs that small business owners have little control over, such as increased wage demands and escalations in rental agreements, mean that South African SMEs are struggling to maintain sufficient profit margins,” says Lang.

He says this limited economic growth means the pie isn’t getting any bigger and that for SMEs to sustain themselves they have to acquire new customers from existing markets or industries, away from other players and competitors in the market. “The quick and easy solution to attract new customers within an existing industry is to reduce prices. However, given the increased competition to retain and attract customers, this can lead to a risk of ‘price wars’ within a certain industry, resulting in profit margins coming under further pressure.”

Understanding costing structures and income and expenditure is crucial to managing and driving profit margins, explains Lang. “Profit margin is made up of variable and fixed costs. Variable costs are incurred when producing or selling a product, while fixed costs, such as rent and wages, are payable regardless of whether the business sells anything or not.

“It is important for business decision-makers to consider these costs when pricing products or services, in order not to compromise on their projected profit margin.”

Lang uses the example: “While reducing prices may bring more customers, overheads, such as rent, remain the same, so dropping prices could also put pressure on margins. Similarly, raising prices could improve profit margins, but this may put the business at risk of being priced above the market and potentially losing customers in the process.

“It is key to understand how customers perceive value and to what extent a business can raise prices to the point that customers will still be willing to pay for the product/service offered. This can be done by finding a unique selling point, such as superior service or quality, that will help the business stand out from competitors,” he adds.

Lang acknowledges that increasing prices may not be viable due to the reality that many business owners are finding themselves operating within the confines of limited economic growth. In such an instance, Lang advises that effectively managing variable costs – such as utilities, input costs such as raw materials and labour - is the next step when reviewing profit margins.

“For example, business owners should negotiate discounts with current suppliers or explore the use of alternative suppliers that can provide the same products or service at a lower cost without compromising on quality. To save on utilities such as electricity or water, a business can make a more conscious effort to utilize these resources more effectively. In terms of labour, businesses can incentivise staff to become more productive and deliver greater output during the same hours. Another aspect is ensuring the business has sufficient security and adequate stock controls in order to minimise theft.”

Lang concludes: “Whichever option a business may choose to maximise its profit margins, it is imperative to refer back to the business plan regularly as this will secure long-term business success, especially during trying economic conditions.”