There is a lot that can be learned from a thorough assessment of the gross profit within a business. And from that assessment a number of options for improvement may become apparent.
Here we explore seven important ways you can assess gross profit in your business.
The revenue received from customer sales is not what the company gets to keep. They need to pay the cost of suppliers and direct line staff which leaves the residual to pay for the overheads and make a profit. Gross profit provides the sharp edge to that realisation. For example, assume the following split for every dollar the business earns:
- Sales $1
- Cost of sales 50c
- Overheads 25c
In this simple example at the first (or Gross Profit) cut the business has 50 cents left after paying the suppliers and labour directly involved in producing the sale. Once the overheads of 25 cents in the dollar are take out that leaves 25 cents left for net profit for the business and the owners once tax (if any) has been paid.
Many businesses will further break these splits down into each component of cost of sales to determine the makeup of the 50 cents. In that way they can use predictive analysis to estimate the results on cost of sales if components of the cost change due to material price increases or direct labour efficiency improvements and so forth.
A typical formula for calculating break even sales is as follows –
Owners remuneration + desired profit + overhead expenses / gross profit ratio
$500,000 + $150,000 + $750,000/.5 (or 50% as a gross profit percentage) equals $2.8m. In other words $2.8m revenue at 50% GP will allow for $1.4m to pay for overheads, profit and owners return.
This becomes a very simple formula to use in terms of determining new breakeven levels of sales to meet changing requirements.
Some time ago a company I was assisting indicated that their gross profit levels were always around 30%. I posed the question: “How do you know that’s right?” to which they replied, “What do you mean, it’s been that way consistently for 5 years”.
Not satisfied with that answer I conducted an analysis as follows:
Step 1: Direct Labour
Analysed their direct labour mark ups and margins which were as follows:
- Direct labour charge out rate per hour $125
- Direct labour recovery 90%
- Net direct labour hour $112.50
- Direct labour cost per hour $40
- Margin per direct labour hour $72.50 (or 58%)
Step 2: Materials
Analysed their average mark up on materials, which was 33% which yields a 25% margin.
Step 3: Mix
- Annual sales were $6m
- Direct labour was 60% of that total or $3.6m
- Direct materials were 40% at total or $2.4m
- Budgeted margin on the labour was 58% as per the above or $2,088,000
- Budgeted margin on the materials was 25% or $600,000
The total margin should have been $2,688,000 or 44.8% however the figure they were achieving was 30%. So what could explain the difference?
Step 4: The findings
An internal investigation uncovered a network of systematic theft by two employers over many years. Poor inventory control and ineffective management analysis allowed this to occur. The employees were dismissed, and the police were informed. The theft cost the company something like $400,000 over a period of 5 years.
The wisdom here is know what your margins should be and if you see a deviation investigate immediately as the causes could be:
- As unlikely as it might seem, theft as in the above real-life example
- Not passing on supplier cost increases at all or in full (including margin) to customers
- Selling a larger volume of lower margin products
- Not passing on labour or production cost increases at all or in full. Absorbing the costs means your gross margin drops, and your break-even level of sales will increase.
In a competitive business world it can be necessary to review the pricing for customers to win new business. Obviously, cutting prices will reduce gross margin unless other cost reductions can be achieved within the business, which may happen on large volume orders if production efficiencies are possible.
However sometimes its more beneficial to consider the incremental profit available when offering a reduced price, as in the following scenario.
One of your major customers approaches you and says that unless you can drop prices by 10% they are going to look for an alternative supplier. Your options are:
- Agree to reduce your prices
- Call their bluff and advise them it’s not possible
- Try and negotiate a lower price drop
- Try to reduce your cost of sales accordingly
- Offer them no price drop but some other product feature or additional service
- A variation of the above
All or some of the above may need to be considered as part of the negotiation process but let’s assume you decide to go with option 1.
The current position looks something like this:
- Current sales price $10 per unit
- Current COS $6 per unit
- Current margins 40%
- Volume p.a. 100,000 units
- Gross turnover $1m
- Gross Margin $400,000
If you refuse to drop your price you stand to lose $400,000 in margin from the current customer. That in turn impacts on the bottom line significantly unless you are confident of replacing that customer with another who can generate similar volumes and margin.
If you drop prices by 10% then the result looks like this:
- Revised sales price $9.10
- COS $6
- Revised margin $3.10 (34%, a drop)
- Gross turnover $910,000
- Gross Margin $310,000
The gross margin has dropped from $400,00 to $310,00 but at least you still have the profit within the business. An old adage that has some validity here is ‘80% of something is better than 100% of nothing’.
If you supply multiple products and services with varying mark ups on cost, then you are bound to have an average gross margin which a net result of the lower and higher margin lines. During the year if variations are occurring then its prudent to drill down to determine the causes and take corrective action where you can.
In the example below you can see that while the average gross profit is 38.75% each individual product line has significantly different levels of profitability.
- Increase volume of sales (new markets, more customers, increased usage)
- Increase prices
- Review the mix of sales to focus on items with higher GP
Reduce cost of sales
- Reduce raw material input costs
- Source from alternative supplier
- Negotiate better prices
- Negotiate JIT delivery with suppliers to reduce carrying costs
- Negotiate volume discounts
- Source cheaper substitute or replacement products
- Reduce out of date stock and/or spoilage
- Reduce manual handling
- Reduce duplicate or unnecessary processes
- Shift rotation
- Collective bargaining
- Invest in new capital equipment
- Re-map the flows from input to output to stores and dispatch
- Improve on the job training
Improve production processes
- Improved scheduling
- Improve quality control turn- around times
- Improve formulations
- Reduce machine downtime
Overhead costs (below the gross profit line) are usually easier to identify and manage. As one can see from the points above there are multiple opportunities to improve profitability in the components that make up cost of sales, with arguably less in the overheads. However, a word of warning based on experience is to not ignore the overheads and assume they are fixed with no room to move.
Here are 5 suggestions for effective overhead management and cost control:
- Carefully evaluate how each category of overhead contributes to profit and/or the overall smooth running of the business.
- Evaluate how much of your overhead is incurred by dealing with difficult clients, out of date working methods, inefficient managers and/or staff, poor use of technology, inefficient distribution methods to market and so forth. Combine exercise with suggestion 1.
- Pose the question, if you took that item of overhead or expense away how would the business suffer?
- Explain to each of the overhead managers that their budget/allocation of funds for the coming year is zero and they must make a submission and build a case for every dollar. That might rattle a few cages!
- Each month select one category of expense for cost reduction, brainstorm all the opportunities, select 1-2 priority choices and make it happen. We have conducted this worthwhile exercise with clients on many occasions.
If you are charged with the responsibility of analysing profitability and recommending improvements, we encourage you to explore the scope that lies in the gross profit area and take action to gain improvements. This is very much the realm of management accounting which is a discipline missing in many businesses that do not have a dedicated resource to undertake these assessments.
It does not matter if you are a manufacturer or service provider, you can use these insights to know what to look for in terms of assessing and proactively managing Gross Profit, the engine room of the business.
1. Revenue or Sales
Income derived from the sale of a product or service.
2. Cost of Sales
The cost of producing that product or service for sale which includes:
- Direct labour
- Direct overheads
3. Gross Profit (or Margin)
The net income remaining after cost of goods sold deducted.
4. Gross Profit Percentage (or Ratio)
Gross profit dollars divided by the revenue.
Cost of sales $10m
Gross profit $10m
GP % ($10m of $20m) = 50%
All the other costs associated with running the business and delivering the product or service to customers. They fall into one of the following three categories:
- Fixed meaning they do not vary with levels of revenue, such as rent.
- Variable meaning they do vary with levels of revenue, such as advertising.
- Semi-variable meaning there is a fixed and variable element, such as phone bills which may have fixed line rental and variable call costs.
6. Net Profit
Is the income remaining once the overhead costs are subtracted from the gross profit. Continuing example above:
Gross profit $10m
Net profit = $3m (or 15% of sales)