Why gross profit is so vital

profit margin

Why gross profit is so vital

Gross profit is possibly the most vital indicator in any business. Your gross profit is calculated by deducting your variable costs from your sales. Variable costs include purchases of stock, direct labour costs (including contractors and casual staff), commissions, credit card fees and freight. These costs are not exclusive – you can include any cost that varies depending on turnover.

Variable costs typically rise as your production rises and fall if it declines. For this reason they are quite distinct from fixed costs that you incur whether or not you sell anything at all. For example, you’ll still need to pay the rent, rates, insurance, salaries and utility bills regardless. These fixed costs are often referred to as operating expenses, or OPEX for short.

Gross profit analysis is typically driven by the gross profit margin percentage and it’s really easy to calculate. First you calculate your gross profit. To do this you deduct your variable costs (of Cost of Goods Sold) from your revenue to arrive at the gross profit in dollars. Then you simply divide your gross profit by your revenue to arrive and arrive at a percentage.

This figure can be compared with other companies in the same industry as you by using benchmarking. You can read more about benchmarking here.

Perhaps an easier way to demonstrate the importance of gross profit is to provide an example. Suppose your business is turning over $500,000 per annum. If you were to increase your gross margin by just 1% you would increase your gross profit by $5,000. Because your overheads are fixed, any improvement will go straight to the bottom line.

There are only two ways to improve the gross margin. You can either increase your price or reduce your variable costs.

Conversely when you discount your price, the impact on the gross profit margin can be severe. If you had a gross profit margin of 30% and decreased your prices by just 4%, you would need to sell 15% more just to stand still. In an increasingly competitive market business may need to increase sales quite substantially to remain profitable.

The only other option is to cut overheads (or fixed costs) and that may require a radical approach in overhauling the way your business operates.

Bear in mind that your gross profit margin also impacts cash flow. If you invest in stock or acquire products, you should typically sell those products or services at a significant markup or profit. By doing so you convert each unit into more cash than you initially invested. If you need funding, the bank will be keen to see that injecting additional cash into the business will be converted into profit.

There’s an old adage in management: “if you can’t measure it, you can’t manage it”. Whilst a large number of KPIs can lead to paralysis by analysis, analysing your gross profit is vital.

If you want to discuss any aspect of this blog in more detail, don’t hesitate to contact us directly. Our Generate Growth and Generate CFO packages may be just the answer with regular meetings to examine KPIs throughout the year.

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