How to Keep Small Orders from Undermining Profit

At a certain point, some small orders become unprofitable – when paperwork, salesperson time, shipping, billing and collection make the order not worth the effort. But sometimes there are reasons to take good care of small orders. One is that small orders may lead to big orders. Another is that many small orders may mean more customers and therein a more healthy diversification of your customer base. Regardless, the task of management is to find ways to improve profit while dealing with competing realities.

The first step toward more profitably managing small orders is to assess your order spread, i.e., what percentages of your total sales volume are from small, medium and large orders. Break down the analysis as follows:

• Number of orders
• Sales total in each category
• Percentage of total sales
• Average sales value per order

Example:

Naturally, you should select order-size ranges that reflect your particular business. Now, compute the average revenue per order. For example, you may find that 300 orders are in the $100 to $500 range but the average is only $120. This may be acceptable, but it may pay to concentrate your sales efforts on, and compensate your salespeople for, moving the average order nearer to $500.

Completing this exercise may take some time, but the information will be well worth it. For example, you may determine that the volume of small orders is so low that you don’t have a problem. Or you may discover that most orders are very small and that you are spending considerable overhead running around filling small, unprofitable orders. By offering a small incentive to your customers or salespeople to increase average order size, for example, you could improve overall profit.

Before we consider ways to boost profit on small orders, ponder the following:

A.    You may discover that a great number of your orders are very small but together sum to just 5% or 10% of total revenue. If this is true, you could probably increase overall profit by simply not filling these orders. But this may not be good business. There are other ways to address this issue (see below).

B.    For most businesses, order processing costs are about the same no matter the order size.

Five Steps to Higher Profit:

Step 1: Calculate Your Annual Gross Profit. It’s annual revenue minus cost of goods sold (i.e., direct costs such as raw materials purchased, factory labor, and other production costs).

Example:

Sales                   $2,000,000

Less Cost of Goods Sold ($1,200,000)

Gross Profit            $800,000

It’s the profit earned and available to pay for sales, general and administrative expenses and capital costs (interest expense and return to equity).

Step 2: Compute your Gross Profit Percentage. It’s simply the gross profit divided by total revenue. In the example above, it’s 40% ($800,000/$2,000,000).

Step 3: Estimate Total Overhead Costs for Order Receipt, Processing, Shipping and Collection. Include the salaries of people who work directly in the order processing and billing departments, annual costs for equipment ownership or rental dedicated to the same, space ownership or rental, etc.

Example: $150,000 a year.

Step 4: Calculate the Overhead Cost per Order. Divide your total estimated annual order cost (Step 3) by the number of orders processed during a year.

Example: $150,000/5,000=$30 per order

Step 5: Calculate the Breakeven Point for Order Size. Divide your overhead cost per order by your gross profit margin.

Example: $30/.4 = $75.

The result is your breakeven order size (in dollars). It’s the order size that results in zero bottom-line profit. That’s because the gross profit earned on the order simply equals your estimate of the direct overhead cost of processing the order.

How to Use It: From a pure dollars-and-cents perspective, one might simply reject any order that does not meet the breakeven order size. But in the real world, that may not be the best tack.

Here are other business steps you might consider to decrease the burden of those no-profit orders.

Increase your prices on smaller orders: Impose a handling or service charge for small orders, e.g., a $15 or $25 charge for orders under $100. That way you recapture some of your cost and still keep the customer.

No commission paid on orders below breakeven. Maybe pay only half commission on orders between breakeven and twice breakeven.

Two-tiered pricing: Raise prices on all product, but offer an across-the-board price break on all orders over a certain amount.

Incentive-weighted commissions: Calculate your profit margin on each product and consider offering your salespeople a higher commission for sales of the company’s most profitable products – and at good quantity levels.

To conclude, profits don’t often improve on their own. Be proactive in managing your business to maximize profit. One important way is making each order profitable.

Finally, don’t be rigid in applying your program. There are exceptions to every rule. For example, suppose you have been trying unsuccessfully to get business from a customer known to buy large quantities. Finally, they send you a little order. You might want to accommodate them!