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Making and Retaining Profit in Your Business

by

George Lee Sye

A guide for small to medium business leaders / owners committed to the

financial success of their business today.

A Soarent Vision Publication

Copyright (2009) by George Lee Sye, all rights reserved.

www.soarent.com.au

To see George Lee Sye in a LIVE Seminar, visit

www.universalevents.com.au for information on upcomingdates and programs



Ultimate Business – Making and Retaining Profit in Your Business

George Lee Sye Page: 2

ABOUT GEORGE LEE SYE

George is the Chairman of Soarent Vision, a company he started in

2002. He specialises in increasing the value of businesses through

effective application of (a) business leadership and business

execution frameworks and (b) improvement technologies.

With customers in the ASX top 200 companies, the positive impact

of his work is felt at many levels inside and outside some of the

biggest and most successful corporations in the world today.

He has written and published 6 books over the past 4 years in the area of business improvement and

personal leadership, including his best selling title Process Mastery with Lean Six Sigma 2nd

Edition. His 2007 published business leader’s guide to the implementation of Lean Six Sigma

( Process Alchemy 2nd Edition) is now being translated and distributed in China by the largest

publishing company in that country, Oriental Press.

He has delivered almost 300 seminars (more than 900 full days of speaking) across the world,

including events in the USA, South Africa, New Zealand, South America and Papua New Guinea.

Over the past couple of years alone, more than 20,000 people have personally experienced his

philosophies in formal training courses, as well as his incredible enthusiasm and energy for life.

Visit http://www.soarent.com.au for more information.

The contents of this eBook were drawn and adapted from

the author’s 2007 publication, Process Alchemy 2nd

Edition.

This practical guide for business leaders and BI managers in

successfully implementing and leading a business

improvement initiative has now been translated and

distributed in China by one of the largest publishing

companies in the world, Oriental Press.





1. BUSINESSES RESPONDING TO THE ECONOMIC ENVIRONMENT

The economic situation now requires businesses, no matter the size, to be far more innovative in

how they operate. In fact let me be so bold as to say this ….. the current economic situation is

causing businesses to do what they should have done years ago; to be more resourceful, to

eliminate the waste from their business that has contributed to a level of performance less than their

potential, and to function as a business should if it is going to create genuine value for all

stakeholders.

The focus of business leaders has fallen back to where it should have been …

… and that is on the economic metrics that ultimately matter when it comes to long-term survival.

THE DANGER NOW is that focus shifts too far to the cost end of the equation and business

owners introduce ‘liposuction’ for business (sucking the fat out that has resided there for years)

without seeing that this is only one piece of the overall performance philosophy.

Pure cost cutting as the only way to maintain profit margins COMES AT A COST!

Particularly when owners of medium to large sized business implement cost cutting solutions

without involving those who work deep in the organisation. Such solutions impact morale,

reputation as an employer of choice, the mindset of those who remain and find ways to work around

leader imposed policies, and the culture of the organization when it comes to the other side of the

financial equation – revenue.

Pure cost cutting for small to medium business owners can cause them to miss out on longer term

opportunities as the ‘cost’ mentality overrides the vital ‘investment’ mentality that all business

owners must have.

With those thoughts in mind, let me describe what I would like to achieve with this eBook.

My desired outcomes for this eBook are four-fold.

1. To expand your awareness of big business thinking.

You would probably not believe how much information and knowledge small to medium

businesses miss out that is made available to the larger corporations. The most knowledgeable

business leaders generally work for or contract to the big businesses because they pay so much, it’s

a simple as that. One of my personal goals is to help small to medium business owners become

more aware of how the most successful companies operate and think. I also want to help set them

up to grow and expand in a way that reflects the mindset and strategies of those whose profits they

would like to emulate.





So be aware that while I spend most of my personal time on the leadership aspects of business,

some of my work will drift more into the technical elements of business profitability, as you will

see in this eBook.

2. To inspire you to retain profit in your business as a part of your long-term wealth creation

strategy.

Almost all of the small to medium sized business owners I have met make one fundamental error …

they follow the advice of their well meaning accountant and do everything in their power to

minimize reportable profit in order to minimize tax. Business owners who follow that strategy will

NEVER create the level of wealth I assume they aspire to create.

3. To present and discuss one approach for identifying profit improving ideas.

Let’s face it; there are many ways to skin a cat, just as there are many ways to identify

opportunities. The approach you choose should come from careful consideration of the maturity and

sophistication of your business, the existing business environment, the company’s culture and the

present focus of those who need to be driving improvement in business profitability.

4. To leave you with some new ideas for how you might approach the identification of

improvement opportunities that have the greatest impact on profit margin.

Notice I said margin ….. not just cost and not just revenue.

When I hear that a company is driving for a 5 or 10 or 20 percent cost reduction a number of

thoughts run through my head. They have no idea what they are doing, they are repeating the words

of their structural superiors [for any number of good reasons], or they are playing a strategic game

to influence the perception of the company in the investment community. Regardless of the reason

it drives me nuts!

MARGIN ….. not cost, must be the primary focus.

A margin focus takes into consideration many factors including cost, revenue and working capital.We want people becoming more resourceful in how they tackle issues associated with increasing

revenue, decreasing fixed and variable costs, and getting working capital out of the balance sheet

and back into the profit and loss statement.

The second focus is cash flow. Not second in importance, only in introduction in this book.





So; now having stimulated your thinking with my opinions, go ahead and have a read. No matter

the size of your business, I trust you will take away some useful ideas that I have drawn from my

work with some of the largest and most profitable companies on the planet today.

George Lee Sye

Brisbane, March 2009

‘Margin, not cost, is the primary focus. A margin focus takes into consideration many

factors including cost, revenue and working capital. We want people becoming more

resourceful in how they tackle issues associated with increasing revenue, decreasing

fixed and variable costs, and getting working capital out of the balance sheet and back into the profit and loss statement.

The second focus is cash flow. Not second in importance, only in introduction in this

book.’

NOTE: The Language of Business

One of the most important aspects of creating wealth from business is understanding and being able

to utilise the language of business. If you don’t understand any of the terminology in this eBook,

simply visit any of the following sites to clarify the meaning of terms.

Forbes Financial Glossary - http://www.forbes.com/tools/glossary/index.jhtml

Investor Words - http://www.investorwords.com/

Financial Dictionary - http://financial-dictionary.thefreedictionary.com/





2. MAXIMISING BUSINESS VALUE

How would you like to be able to create the kind of wealth you see detailed in BRW’s

Rich 200 list?

Well that kind of wealth will never be created if you spend your time trying to reduce the level

of reportable profit in your business for the purpose of reducing your tax burden.

Tax minimization is a great strategy, one that is promoted universally by accountants. I totally agree

that no person or organization should pay more tax than is necessary. However, when you begin to

dilute company profits wholly and solely for that purpose, now you are (a) conditioning a mindset

that is in direct conflict with your wealth creation goals, and (b) diluting your own wealth.

In taking a look at how the rich business investors create wealth, my presupposition is this:

• You are in business for the purpose of creating a lifestyle and generating wealth for yourself

and your family

With that in mind, lets take a look at valuing a business.

Your business can be valued using a number of methods, here are three ways.

1. Asset Value

This approach provides you with an indication of value derived from the costs to replace the

tangible assets of your business. If your earnings don’t support a value greater than the value of

assets, then the value of your business, at best, is the value of its tangible assets.

2. Market Value

This method provides an indication of value using ratios or factors derived from the earnings, sales

and/or assets of similar businesses. These ratios or factors can then be applied to your business’s

sales, earnings and/or assets to give an indication of value.

3. Multiple of Earnings

This method determines value by converting earnings into a value using a capitalization rate,

discount rate or multiple (for public companies you will know this multiple as the Price Earnings

Ratio or PE Ratio). This approach requires some level of earnings and a conversion factor to

convert the earnings into a value. Effectively matching the selected level of earnings (before-tax,

after-tax, discretionary earnings, future earnings or some form of cash flow) with the correct

conversion factor (capitalization rate, discount rate or multiple) is the key to obtaining a reasonable

and supportable indication of value.





Maximising Value by Maximising Earnings

The method frequently used by business brokers and appraisers to produce an indication of business

value is the Multiple of Earnings Method. Calculating value with this method is a three-step

process.

Step 1: Determine earnings likely to occur in the future.

For the purpose of this calculation, earnings for a small to medium business can be defined as

reported pre-tax profit + your salary + interest expense + depreciation + any personal expenses you

put through your business.

Future earnings can be determined by either of these ways:

• Averaging the last several years of earnings and assume they will continue; or

• If your most recent year is more indicative of what you expect to be on going, then you can

use this past year's discretionary earnings.

Step 2: Determine the multiple (multiplier).

The greater the future earnings potential of a business, the higher the multiple.

The range of multipliers applicable to small to medium sized private business is up to around 5.

Publicly listed companies enjoy a much higher range. According to professional business appraisers

I have spoken to, most profitable small businesses sell in the range of 1.5 to 2.5 times earnings.

Step 3: Calculate the value of the business.

It’s now a simple matter of inserting your numbers into the equation and calculating the value.

Value = (Earnings x Multiple) + Additional Value

The value that results from this calculation includes all of the tangible assets required to operate the

business, whereby tangible assets includes items such as the plant, fixtures, furniture, equipment

and any inventory.

The additional value that you can choose to keep or sell with the business is the net liquid assets

(which includes cash and accounts receivable less accounts payable) and non-operating assets

owned by the business such as the car you drive.

So, if a business generates earnings of $100,000 and the business is considered average, then we

might choose a multiple of 2. The value of that business would be 2 times $100,000 = $200,000

plus the value of net liquid assets.





So why would you want to retain earnings in the business?

Let’s look at two scenarios that are self-explanatory using a gross earnings value of $100.

Scenario 1 – Reduce Earnings Scenario 2 – Retain Earnings

Reduce reportable earnings by $100 (e.g. you

draw $100 in salary)

You pay personal tax on $70 (lets assume 48

percent)

You personally net $36

$100 is retained in earnings

Pay tax of $30 (based on 30 percent company

tax rate)

$70 remains as net earnings

Assuming a multiple of 2 x $70 = you receive

$140 when you sell the business

You pay personal tax of $67 (applying a 48

percent tax rate)

You personally net $73

Notice the same amount of money retained is worth much more when a valuation multiple is

applied to it. Obviously a larger multiple means much greater wealth generation, something the

most successful investors are very much aware of.

While there is much more we can discuss around this topic, you now have the basis for

understanding how the rich get richer when investing in business.

So if you are seeking wealth creation from business, why don’t we go ahead and see how we can

maximize the reportable earnings of your business?

3. BUSINESS DRIVERS

This approach to identifying profit improving opportunities is based on understanding the

relationship between business drivers, processes and organisational value.

The higher level business goals or objectives of an organisation will determine what

the key drivers of the business are.

These key drivers will determine your core business processes – those that actually create value

that is linked to high level business goals, and those that enable (or support) the creation of value.

Within each of these processes, there will be elements that drive operating cost, capital expenditure,

working capital, revenue and risk exposure.





Operating cost, capital expenditure, working capital, revenue and risk exposure are consequences or

benefits (depending upon which way you look at it) of which the business itself is a customer. At

the macro level, these will drive the commercial value of your business.

Figure 1: Business Drivers

I know your wondering how does knowing this fit in with our discussion around identifying

opportunities for profit expansion. Well hang in there, it will become clearer as you read more.

Continual improvement is the key to success

While ‘defect reduction’ was the primary focal point of ‘continual improvement’ or ‘business

improvement’ in its traditional form in large corporations, not all profit improving opportunities

have to be focused on reducing defects with respect to product or service quality. While product

quality improvement can impact both revenue and costs, we can and should have a much broader

focus. All of your work on improving your business should be aligned to the higher level objectives

of your business, and the most critical of these will be financial. So if you are able to target those

things that drive those figures, then you will be in a good position to make a valuable contribution

to your business and its stakeholders.

There are principally only five areas of focus for you:

1. Reducing your per unit cost of production;

2. Reducing your level of working capital;

3. Reducing capital expenditure;

4. Reducing risk exposure; and

5. Increasing throughput or sales volume.





These focal points can be problem driven (waste, re-works, bad debts, increasing cost of capital,

short equipment life cycles, exposure to hazards, bottlenecks etc), or a proactive approach targeting

the biggest drivers of cost, working capital, capital expenditure or revenue (cycle time, inventories,

plant life cycles, throughput, sales volume, lead generation etc).

The most effective work I have observed in this area for medium to larger organisation has been

achieved when analysing specific areas or functions within the business. For example plant

maintenance or logistics can undertake this approach within their own area while production does

the same in their area. For smaller businesses this may or may not be relevant.

The Most Common Drivers

The following table presents some examples of common types of drivers to consider.

Item Drivers

Capital Expenditure Equipment and Plant Life Cycles (computers, office machines,

vehicles etc)

Working Capital Trade Debtors / Stock Inventory / Parts Inventory / Work in

Progress

Operating Costs Power / Labour / Equipment Hire / Fuel / Consumables / Phone

Expenses / Rent / Subscriptions / Maintenance

Revenue Production Volumes / Production Cycle Time / Delivery Cycle

Time / Lead Generation / Sales Volume

Risk Exposure to Hazards / Missed Business Opportunities

Now as a business owner, it you were able to affect these drivers in some positive way, how would

that impact your business? Clearly the impact would be seen in financial results. For example if you

were able to reduce the cycle time to receive payment from your customers (accounts receivable),

that would increase your cash reserves. If you were able to reduce your internet and phone costs,

that would increase your profitability. If you could reduce the level of inventory you held and still

meet the demand of your customers, that would reduce how much money you had sitting there

doing nothing in the store, does that make sense?

Every single driver can be positively impacted, either through applying some improvement

methodology like Lean Thinking, or through implementing some appropriate operating strategy

such as Joint Venture development or Internet Marketing. You just need to (a) know where to focus





for the greatest impact, and (b) become more innovative and curious about what is out there that

you don’t know yet.

4. CHOOSING THE RIGHT FOCAL POINTS

Identifying The Right Focal Points through Driver Identification

The process for identifying potential areas of improvement for your business is quite simple. All

you have to do is ….

Focus on a functional area of your business (production, sales, accounting and admin, supply

etc); and

Ask the right questions (of the right people if you have employees).

The right type of question will focus discussion and generate relevant ideas. People already knowthe answers, all you have to do is extract them. Let me offer you some suggestions as to the types of

questions to ask.

Oh, by the way. I might start using the words ‘improvement project’ as this is essentially what we

are doing … helping you pick out the focal points in your business where you can focus your

energies in order to impact the profitability of your business. In effect undertaking a project.

Okay, back to the questions.

The first question to ask is designed to identify the drivers for each of the elements associated with

your higher level business objectives.

For example:

Q. What drives working capital within the functional area we’re focused on? These items are

brainstormed and discussed before repeating the question for each of the driver categories –

operating cost, capital expenditure, revenue and risk. In this particular case, we might get answers

like trade debtors, stock inventory and parts inventory.

Item: Drivers:

WORKING CAPITAL Trade Debtors / Stock Inventory / Parts Inventory / Work in Progress

To get to the real improvement level, simply continue to ask questions that help you drill down. The

questions I’ve found most useful include these:





Q. What is the primary driver we are going to focus on?

This may be answered better when information is available that provides a breakdown of values for

each of the drivers identified in the previous question. In this example we might choose 'Parts

Inventory'.

Financial Item: Drivers:


Primary Driver: Parts Inventory

Contributing Variables:

Q. What variables contribute to variation in this driver? This question can be asked multiple

times to help drill down even lower, although this is not essential. In this case we might get answers

like time to receive inventory, item cost, accuracy levels.




Contributing Variables: Time to receive / item cost / inventory errors

All we are doing is breaking down to lower level variables that contribute to your business drivers.

The process is simply a way of understanding cause and effect relationships.

Continuing with the example, when you decide what variables to focus on, you can then ask the

next question.

Q. What is a potential improvement project? In your answer, use a phrase that includes a verb

such as reduce, minimise or increase etc. (e.g. Reduce lead times, Reduce purchase costs, Increase

inventory accuracy.)





3 Potential Projects: Reduce Lead Times Reduce Unit PurchaseCosts

Increase InventoryAccuracy

Reasonable

Improvement Level

Value to the Business

Process Owner





Q. What improvement level would be a reasonable target? Specific goals can be defined at this

time. Where there is insufficient information to define straight away, these can be defined later.

Q. If the target was achieved, what value would that add to business? If the impact can be

estimated in financial terms, this will help in the process of project prioritisation when all

opportunities are collated.

Q. Who is the owner of the process? The process owner will be a suitable project sponsor.

(NOTE: This will only apply to businesses where there are reporting layers and clear

responsibilities.)

The outcomes of this discussion might look something like this.





3 Potential Projects: Reduce Lead Times Reduce Unit PurchaseCosts

Increase InventoryAccuracy

Reasonable

Improvement Level

10% reduction on average 5% reduction on average Increased from 75% to

90%

Value to the Business Value of on-hand reduced by$XX

Value of on-hand reduced by $10,000

Reduced airfreight costs of $2,000 pa

Process Owner Michelle Stevens

(Supply Suppervisor)

Steve Jacobs

(Purchasing Supervisor)

Fred Dutton

(Store Supervisor)

At the end of this questioning process it’s possible to create a list of potential projects that are all

linked to the higher level objectives of your business.

Why is it important to carefully choose where you focus your improvement

attention?

The Business Improvement Manager of a major Australian corporation once said to me; if you want

leaders to allocate resources to any business improvement work, it must do three things:

1. It has to focus on work that is recognised as important;

2. It has to get results; and

3. It has to realise benefits quickly.





By working on projects that are linked to the higher level objectives of your business, work is

more effectively connected to the execution of your business plan.

In reality, your business plan should drive the allocation of what are really resources. The General

Manager of business improvement in Telstra was on the mark when she told me that choosing to

focus on areas of improvement linked to the higher level [strategic] objectives of the business is an

important element in managing the wrong perception that improvement is a separate activity to day-

to-day business, and not an integral part of the way a company should work.

Figure 2: Three Conditions for Getting Resources

Business Driver Tree

The cause & effect relationship between revenue, working capital, cost and their drivers can be

explored much deeper with the development of 'Driver Trees'. A driver tree, as used by many of the

larger organisations, is simply a ‘tree diagram’. It is one of the seven management and planning

tools described by Japanese contributor to quality concepts, Shigeru Mizuno.

Whilst the use of a driver tree is not essential, by using it in conjunction with the questioning

process, it can help in a number of ways - (a) in identifying specific areas for improvement, or (b)

helping business owners and managers understand the drivers of their business in a more detailed

and visual way.

A driver tree is usually laid out in a format not unlike an organisation chart. The driver tree shown

in the figure below was developed simply by asking the same ‘What drives this?’ question over and

over for each level. For example: ‘What drives operating costs?’

Discussion for our example revealed that operating costs was driven by fuel costs, power costs,

equipment hire costs, consumable costs and so on.





5. SUMMARY

Well that brings us almost to the end. I know we’ve covered quite a lot of ground in this topic, so

it’s important that I begin to close by summarizing the key points.

1. Cost cutting on its own is a poor strategy for creating wealth, having a cost minimization

mentality alongside an investment for growth mentality is key.

2. Profit (earnings) retention is vitally important in creating wealth from business; remember

retained earnings are multiplied when calculating the value of your business.

3. There are principally only five areas of focus for you in creating maximum value from your

business.

a. Minimising your per unit cost of production;

b. Minimising your level of working capital;

c. Minimising capital expenditure;

d. Minimising risk exposure; and

e. Maximising throughput and sales volume.

4. One way of identifying where to focus your energies is to understand those things that really

drive the financial elements of your business – cost, revenue, working capital, capital

expenditure and risk.

6. CONCLUSION

I hope that in giving you some idea how the most successful corporations approach these issues, I

have contributed to your success in business and your long-term wealth creation goals.

Let me leave you with this thought.

No single methodology or strategy of improvement is the panacea of profitability; they are all

important elements that must be wisely chosen and integrated into a consolidated method for

executing your business plan.

If you just apply some key principles, success is virtually guaranteed. Good fortune in your

business efforts.

George Lee Sye

_______________________





To see George Lee Sye in a LIVE Seminar, visit

www.universalevents.com.au for information on upcoming

dates and programs

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