Most UK SMEs are profitable, with 79% of small companies turning a profit in 2022 [1]. But how many of these companies are confident they’re making the best possible profit? Read on to discover how to adopt a strategy of profit maximisation – while avoiding the pitfalls of focusing on profits at the expense of your company’s long-term success.
Summary
- What is profit maximisation?
- Profit maximisation formula
- Advantages of maximising profits
- Risks associated with profit maximisation
- 5 tips to maximise profits
What is profit maximisation?
Profit maximisation is the process of identifying the optimum level of production output and pricing to achieve the highest possible level of profit. In other words, how much should your company produce, at what cost, to deliver the best return?
To do this, companies must first identify the marginal cost of a good or service. This is the additional cost of producing one more unit of output.
Profit is maximised when marginal revenue (the additional sales generated by the extra unit) is equal to the marginal cost.
Calculating profit maximisation
While there is no direct formula for profit maximisation, companies can calculate marginal profit using the formula below to identify the point where marginal revenue equals marginal cost.
Marginal Profit = Marginal Revenue - Marginal Cost
Profit is considered maximised if marginal profit equals zero in the above calculation. When marginal profit is above zero, the business is making a profit but there is still room to profitably increase production.
The goal of profit maximisation is to keep producing and selling more until the business is at its maximum profitable capacity i.e. when marginal revenue is equal to marginal cost. It is at this point - where marginal profit equals zero - that the company is operating as profitably as it can.
Once the figure dips below zero the company is making a marginal loss and additional production makes little sense until changes are made in areas such as pricing and production efficiency.
Example of profit maximisation
If a shop wants to increase profits they might decide to extend their opening hours. The question the business must ask is, “How many extra hours should we open the store to generate the highest possible profit?”
The company forecasts that extending its opening hours by one hour each day will generate £10,000 in additional sales, increasing net profits.
A profit maximisation strategy, however, will also consider the cost of production in opening for another hour. This might include additional work, paying additional staff costs, and increasing utility bills. If it costs the business more to open the store for an additional hour than the additional revenue, then the change is not likely to maximise profits.
In this example, profit is maximised when the marginal revenue of the store being open longer is equal to the marginal cost of extending opening times.
Advantages of profit maximisation
The ultimate goal of profit maximisation is to increase your company’s profits to support future growth and success. The benefits of successful profit maximisation include:
- Positive cash flow: Since marginal costs are equal to (but never higher) than marginal revenue, profit maximisation lends itself to creating positive cash flow, and increased cash flow availability.
- Shareholder value: Higher profits mean more value for shareholders, which could help your business to attract new investment and partnership opportunities.
- Strong growth prospects: Profits provide cash to invest in expansion and growth, while higher production leads to job creation and sustainable growth.
Risks of profit maximisation
It’s important to remember that profit maximisation is not about increasing profits at all costs. Companies must not prioritise profits if that strategy puts the long-term success or stability of a business at risk, says Moses Nalocca, business coach and CEO of Upper Echelon Coaching Academy. Common pitfalls of profit maximisation can include:
- Brand reputation: If your customers feel that they are not valued and your company sees them as only a source of profits, then you may see lower levels of customer loyalty if a competitor offers a better service, notes Nalocca. “Customers love to buy, but they don’t want to feel sold to,” he says.
- Inferior products: Profit maximisation could be bad news for customers if you reduce costs by using cheaper materials or cutting back on product quality. While lowering production costs can increase gross profit in the short-term, customers will notice any decline in product quality, which could ultimately drive them away.
- Inflated prices: Increasing prices is a great way to increase revenue and profits, but if your prices are not competitive, or if price increases are unwelcome, then customers are likely to be dissatisfied and may look elsewhere.
5 tips to maximise your profits
If you want to maximise profits in your business, you’ll need to identify ways to increase revenue and decrease costs while maintaining customer satisfaction and long-term sustainability. Below are some examples of ways this might be achieved:
Increase business prospects
Even a slight increase in business prospects through marketing or lead generation can deliver a substantial increase in revenues, says Nalocca. “A slight increase in prospects by just 2 or 3% has an immediate ripple effect on revenues, and you’re able to compound that to scale your business revenues,” he says.
Expand product offering
If you want to increase revenues without increasing costs then one of the best strategies is to identify cross-selling and up-selling opportunities and refreshing products at the end of the product life cycle. “Consider what elements in the market are complementary to your current offering, and consider how you can sell those, through a partnership or by acquiring another supplier,” advises Nalocca.
Keep loyal customers coming back for more
Mochi ice cream company Little Moons keep its loyal customers coming back for more by focusing on high-quality products that create a feeling of value, says co-founder Vivian Wong. “We often choose more expensive, better quality ingredients that result in better-tasting products despite a direct hit to our bottom line."
Engage employees to increase productivity
Keeping employees engaged to increase productivity is an idea that strikes a chord with Little Moons, says Wong: “We’ve always prioritised our people’s wellbeing. How they feel and their engagement are top of our list, so we’ve always ensured that improvements don’t adversely impact them, their working practices and environment,” she says. “Profit is more than just revenue minus costs, it’s about meeting the needs of all our stakeholders.”
Reduce overheads
Companies can reduce overhead costs by analysing where money is being spent and where it can be saved, in order to maximise your operating profit.
“To make the right decisions, you must have a clear picture of your costs structure and where value is generated and lost,” Andrew Elliot, CEO and founder of the London Consulting Group, “when we started our business, we decided to manufacture our products. While this resulted in increased capital outlay, it’s meant that we’ve benefitted from economies of scale as we’ve grown as well as improved efficiencies through learning and process improvements.”
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Sources
[1] UK Department for Business and Trade, Longitudinal Small Business Survey: SME Employers, UK, 2023
