Sure, you might be doing the work and getting the product/service out the door, but GP margin will tell you how efficiently this is happening. It can be calculated by taking Sales less your cost of goods sold expressed as a percentage of total sales. (more about that later)Here are some practical examples of staff affecting gross profit margin:
- A café Kitchen hand overfilling sandwiches
- Too many checkout staff rostered and not being sent home
- Employees flying interstate for sales meetings
- Delivery drivers filling up their trucks in regional areas (where prices are usually higher)
The figure is important because:
- It is a fantastic tool to help businesses make informed decisions about maximising profitability through efficiency and in determining the correct product mix and price points for your business. (more about this later)
- It can be used to compare businesses in similar industries. Industries will generally have standard gross profit margin ratios, which are easily discovered and can be used for benchmarking to tell you how competitive you are in the market place.
- It can also be used as a measure of what type of business to buy, so if you are looking to sell, you want to be competitive against other types of businesses.
- It can help you determine your breakeven point. (The amount of sales you need to make to pay for your fixed costs such as rent, loan payments, utilities etc.) You should note though, that if you overestimate your GP Margin you will underestimate your breakeven point.
- Unless you’ve put in a price rise (another way to affect GP Margin), if the number increases, it means your business is getting better at what it does; your business is becoming more efficient.
- Fluctuations can flag the possibility of financial fraud, accounting irregularities or problems in the business, because gross profit margins tend to remain stable over time.
- It can help with “what if” type questions such as impact of price increases. If you know your GP you can determine much you can “afford” for your units of sales to drop by, before your price increase starts to affect your net profit as it is today.
As the adage goes, “In God we trust, everybody else bring data”. If you are making strategic decisions in your business, they should be backed up with quality, accurate data and one of the key indicators in your toolbox should be Gross Profit Margin.
How to work out your Gross Profit margin
- To determine the Gross Profit Margin you first need to determine your Cost of Goods Sold. (also known as direct costs or variable costs) This is how much it costs you to actually produce the product or service your organisation sells. It will be different for different businesses. Here are some examples:
-A delivery company’s direct costs would be fuel, delivery wages, Repairs and Maintenance on their vehicles etc.
-A café’s direct costs would be anything related to the cost of the food and the cost of the staff who make and serve the food. (wait staff wages and super, food costs, napkins, laundering table linen etc)
- Once you know which costs these are you need to find a way to accurately measure them. Usually these are built into your accounting system and you may need to speak with your bookkeeper about HOW you want information captured so that you can use the financials to help you make informed business decisions (rather than capturing the information for taxation purposes)
- Thirdly you need to calculate your GP Margin. This is usually expressed as a percentage and sometimes calculated automatically in different software packages, or it can be easily calculated by expressing the following calculation:
Once you’ve worked out your GP Margin, you should set a target to improve the figure over time. Car manufacturers wanting to improve fuel efficiency of their cars would look at things like the weight of the vehicle and other factors. In your business, improving the efficiency of your operations would involve considering things such as product line deletions/additions, automation (to reduce labour costs), maintenance contracts (to limit maintenance costs) etc. You would look at all of your systems and ways to reduce your purchasing costs.
You should also monitor your GP Margin regularly. This is your gauge about what is happening in your business. If it starts decreasing rapidly, it can signal where to take a closer look in this area and take action to address the problem.
Once you’re comfortable, you can carry out the same process to look at GP Margins for different products and services within your business. This will tell you which products are contributing the most to your net profit and may be worthwhile investing more into.
You can also use GP margins to drive your business decisions or strategies. A key example is the decision to increase prices or offering discounts. By using your GP Margin, you can assess the impact of price changes to your business on paper.
Take a look at the scenarios represented in the table below about a company who sells 100 000 widgets (why do they always use widgets for these examples?!) at $6 per unit. The resulting income is $600 000 less the cost of sales at $400 000 leaves a gross profit of $200 000. Using our formula we calculate GP Margin at 33%. ($400 000/$600 000)
|Current Situation||Improve GP Margin by 2%||Offer a 50 cent Discount||Increase Unit Price by $1|
|Price Per Unit||$6||$6||$5.50||$7|
|Cost of Goods||400000||390000||400000||400000|
|Gross Profit Margin||33%||35%||33%||43%|
|Net Profit Margin||13%||15%||13%||26%|
|Breakeven Point is||360000||342857.1||360000||280000|
In the first scenario (improve GP Margin by 2%) you’ve immediately dropped your breakeven point from $360000 to $342857 and improved your net profit by $10 000. This means you start contributing to net profit sooner AND at a higher rate.
In the second scenario, you can see that by offering a 50 cent reduction in the cost of your product or service, you need to increase sales by another 9,090 units to make the SAME net profit that you are making presently. That is without taking into account the costs involved in creating those additional units. Ie. Need more wait staff to serve additional customers etc.
In the third scenario, you can see that GP improves by $100 000 by increasing your price and your breakeven point drops to $280 000.
In the example above, you could afford to lose 14 286 units in sales, before you would need to start worrying that the price is too high.
A cautionary note
GP margin should not be the only KPI when measuring the financial health or profitability in a business, as it needs to be reviewed in conjunction with other factors.
For example, consider the following:
- If the product with low margin is a high volume item, then you may be throwing the baby out with the bath water. Obviously the decision needs to be made in conjunction with the actual gross profit $’s this contributes to your business, especially if it is a major contributor to your overheads/indirect/fixed costs.
- If the product has a relatively inexpensive cost base, (ie. The cost of coffee beans for a coffee shop), but other costs of sales are driving the GP margin down, you may need to consider other ways of lowering the GP Margin before ditching it all together. Eg. Automation, outsourcing, compromising a little on customer service to lower wages costs etc.
- The decision to sell low volume products with high GP margin with an expensive cost base. Even though the GP Margin is high in this scenario it may still not be worth carrying on with it in your product/service offering. Eg. You make 80% GP on an item, but it has a huge cost base to buy and keep in stock and you only sell 3 units per annum.
- Do low margin products help generate higher margin sales? Many organisations intentionally promote a low margin item because it gets people buying their products and there are greater opportunities for upselling to higher margin items once they are in the door.
- Discounting has it’s place. In the discounting scenario above, it may still be a good strategy to follow if the product is slow moving or obsolete and there are other strong business cases for the decision to offload the product.
- For many businesses, low margin high volume products help accelerate overhead recovery, which means that even though the GP margin in % terms is low, the bottom line profit is higher. The exact opposite may arise when selling low volume items with a higher GP margin.
- Also, be aware that the factors impacting gross margins may change over time. For instance, as your business develops, you may begin generating enough cash to be able to take advantage of volume purchasing discounts or discounts for upfront payments. You may also find that your costs increase due to inflationary factors and that you need to compensate for this with annual price increases.
Essentially, without knowing your GP Margin, you can’t even begin to have an informed conversation about improving efficiencies in your business.
Understanding your business and providing a balanced product mix that continually meets a dynamic market along with a balanced GP margin will go a long way to help businesses succeed.