The dilemma on whether to grow revenue or cut expenses to increase profitability has perplexed small business owners for generations. In frustration, many decide that they want to do both at the same time! Typically, this is not realistic.
The correct answer on whether it is best to grow revenue or cut expenses to boost short term profitability depends basically on the gross margin of the product that is sold.
As a general rule, with a higher the gross profit margin, the company will have more leverage if it invests in boosting revenue, instead of just cutting expenses. For lower margin businesses, they should focus on cutting expenses initially for maximum impact. This formula works because the same $100 of sales in a higher margin business brings higher gross profits to cover expenses.
Here is the arithmetic on whether to grow revenue or cut expenses:
Company A sells a product that has an 80% gross profit margin. This means that a sale of $100 yields $80 gross profit to cover other expenses. Company B sells a product that has a 25% gross profit margin. This means that a sale of $100 yields a $25 gross profit to cover other expenses. Therefore, with the same $100 of sales, Company A has $80 left to cover other expenses and Company B has only $25.
Alternately, if Company A has a $50 overhead expense they want to cover, they need to record a sale of $62.50 (80% gross profit margin of this is $50). If Company B has a $50 expense they need to cover, they need to record a sale over three times higher at $200! (25% gross profit margin on this sale is $50). In this case, with a lower margin, it can be more impactful for Company B to focus on cutting expenses to increase immediate profitably instead of boosting sales since gross margins at 25% are low. For them, a $50 cut in expenses is like a $200 boost in their sales!
If it takes equal effort for Company A and B to generate $100 in sales, Company A should focus on increasing sales and Company B should focus on cutting expenses since Company B will have to generate over a three times higher sales to cover the same level of expenses with their lower gross margin.
This is a just a general guideline on the decision to grow revenue or cut expenses. Each business has to decide the level of difficulty for growing revenue or cutting expenses that will have the best long term impact on the company.
