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Join the Profitability Revolution
Business Transactions
In order to properly turn the business owner’s investments into working capital, it is best to compare the profitability of one investment strategy with another alternative strategy. This is hard to do, because traditional financial tools make it difficult for most businesses to keep track of the profitability of strategic alternatives. Comparisons of profitability between various strategies can be made irrefutably when working capital investment is associated with individual sales transactions of the business. This 3W Business Profitability Analyzer Web Site is dedicated to providing the comparative financial tools that make it easy for the businesses to track the investment of alternative investment strategies. The key to analyzing comparative investment alternatives lies in preparing a business transaction definition that reflects the business.
Throughout this 3W Business Profitability Analyzer Web Site a particular business transaction is completely analyzed to produce a profitability rate. Then the profitability rate is compared to the profitability rate of the same business transaction using another strategy. Therefore, it becomes easy for the business person to understand which strategy is more profitable.
Understanding how to compare business transactions is much easier than creating a definition of a business transaction on paper that reflects the business. The revenue of business generally is not a result from one sale. It happens as a result of many sales to various customers. Each sale is a business transaction, and for each business transaction an investment of the company’s working capital is required. It is this investment of working capital and the return in profits that dominates the contents of this analysis.
If a business has only one business transaction working at any time, then it is very difficult to enhance the profitability of that one and only business transaction. Fortunately, most businesses have many individual transactions in progress at the same time. The working capital is indispensable and is used to fund all the transactions simultaneously. When the business employs certain Alternative Financing Strategies, the working capital requirement is significantly reduced.
The activity that makes a business more profitable is, either the gain in market share or the reduction of the working capital requirement. This 3W Business Profitability Analyzer Web Site focuses upon working capital reduction. If some of the working capital requirement for a transaction can be relieved and used in another transaction, then two transactions are supported by the same working capital. This means the working capital requirement is reduced overall, and the money saved can be used to increase profits or used to expand the business.
Defining a Business Transaction is an Art Form
Defining a business transaction is not necessarily an easy task to put on paper, especially if all the essential information is not available. Besides timing, the primary components used to compare the profitability of one transaction with another are the cost of goods sold (or services sold) and gross profit. Together, the two components add up to the total Sales Revenue. Furthermore, the cost of goods sold (COGS) represents the variable costs associated with the transaction and is subdivided into hard costs and soft costs. The soft costs represent the non-material costs affiliated with the transaction whereas the hard costs represent the material costs associated with the transaction. Soft Costs include direct labor, and other variable overhead. Hard Costs include supplies, materials, equipment, shipping, etc. The Gross Profit of the transaction should represent the total contribution to fixed cost. The fixed cost for the business represents the cost of administration. A typical Income Statement can provide most of the information needed to describe a Business Transaction, provided estimates the avarage invoice amounts.
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Business Transaction | |
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Sales Revenue |
Cost of Goods Sold |
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Hard Costs |
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Soft Costs |
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Working Capital Timing |
Number of Days is Required |
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Accounts Receivable Timing |
Number of Days Outstanding |
Business Transaction Definition
It is easier to define a business transaction than to actually attach the exact amounts of a sale to Hard Costs, Soft Costs, and Gross Profit. The reason for this is that most business executives when looking at a balance sheet or a profit and loss statement do not find their business broken down in the manner needed for comparative purposes. Also none of the standard financial reports shows how investment of working capital is used for a typical transaction (an aging report helps, but it does not state when the outlay of working capital was used). On many occasions the fixed and variable costs are intermingled, overhead is not usually separated into fixed and variable components, and labor is sometimes broken down into administrative and direct costs. In short, it is difficult to know precisely how to define a typical transaction for the business. Timing is perhaps the most important element in defining the typical transaction and standard reporting techniques ignore timing completely. Without this information, the profitability comparisons would be impossible.
To assist the business person to define the typical transaction, here are few tips:
Typical Transaction Revenue <Average Transaction Revenue>
- Take the total annual income on the Profit and Loss Statement and divide that amount by the total number of annual sales invoices sent to the customers of the business. This Sales Revenue would represent the average total amount of the COGS and Gross Profit
Typical Variable Cost <Average Transaction COGS>
- Take the total annual inventory on the Profit and Loss Statement and divide that amount by the total number of annual sales invoices to the customers of the business. This would represent the average Hard Cost of COGS associated with the business.
- Obtain the total amount of payroll, including benefits, and remove the administration payroll. The difference represents the direct payroll. Divide the direct payroll amount by the total number of annual sales invoices to the customers of the business. This would represent the average Soft Cost of COGS associated with the business.
- Add the average shipping cost to the Hard Costs of COGS and the average manufacturing plant and equipment cost to the Soft Costs of COGS.
- Sometimes it is easier to back into the COGS because the contribution to fixed cost can be pulled from standard reports for business. So if either the Hard Costs of COGS or the Soft Costs of COGS is unknown (or difficult to figure out) back into the answer by using the other three known answers.
Typical Gross Profit <Average Contribution to Fixed Cost>
- Subtract the COGS from the average Sales Revenue to define the Gross Profit.
Typical Transaction Timing <Average Time Working Capital is Required>
- Take the average Accounts Receivable Timing from the aging report for the business.
- Average the lead time requirements for supplies and materials. If suppliers offer the business credit terms for supplies purchased, subtract the number of days of credit that is being extended. This net difference of time should yield an approximation of the number of days working capital (Lead Time Payment Timing) is required prior to invoicing the customer. The Lead Time Payment Timing plus the Accounts Receivable Timing would add up to the Working Capital Timing, i.e. the total time the working capital remains outstanding.
Another method for defining an average business transaction is the "bottom up" approach. Sometimes it is easier to define the transaction this way. Consider the example of a clearing house services provider for a manufacturer who retrieves maintenance information from various independent maintenance providers (repair centers) that service the manufacturer’s products.
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Example Clearing House Business | ||
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Main Processing Center | ||
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Repair Center #1 |
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Manufacturer #1 |
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Repair Center #2 |
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Repair Center #3 |
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The business is a clearing house for the customer, a large manufacturer, and its mission is to retrieve maintenance records from various small business repair centers throughout the country and return those records to the customer. The business transaction is summarized as follows:
- The Small Business Repair Center is paid $30.00 up front for a maintenance record and returns the record within 9 days.
- The Customer pays invoices ($44.00) in 14 days.
- The Direct Labor Cost (Soft Cost) for handling 650 records per month at $9.00 per employee (total $1,560 per month ) is $2.40 per transaction.
- Shipping cost for sending the Repair Center a check is normally $0.32 (postage).
- Shipping cost for sending customers the records is $20 per 50
records or $0.40 per record.
Working Capital Funded by the Business
1 4 Day A/R
Production Hard Costs (Paid 9 Days before Invoicing) (COGS)
$30.32
Production Soft Costs (Paid 9 Days before Invoicing) (COGS)
$2.40
Wait Time before Invoicing Customer (Days
9 Days
Production Hard Costs (Paid at Invoicing) (COGS)
$0.40
Business Delivers Goods and Invoices Customer (Days)
1 Day
Wait Time before Customer Pays (Days)
14 Days
Customer Payment
$44.00
Gross Profit
$10.88
Example Transaction Definition
Regardless which method is used to create the transaction definition (Revenue, Hard Costs, Soft Costs and Timing), this provides the information necessary to address different strategies that will be used to compare the profitability between the strategies.
3W Internet Corporation commits its resources to support every alternative financial specialty that is described in this primer. Although all the computations featured in this document have been thoroughly checked and tested, there may be some functions that rely upon other financial concepts methods, strategies and ideas using software, and protocols not developed by 3W Internet Corporation.
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