The Importance of Gross Profit and Gross Margin


The Importance of Gross Profit and Gross Margin

Gross profit and gross margin are two key numbers in every business.

They are also the most confusing and least understood. When focused on however they invariably increase profit and cash flow.

Let’s start by identifying what these two numbers are:

  • Gross profit is the difference between the selling price of your products and services and their costs.
  • Gross margin is a percentage calculated by taking the gross profit and dividing by the revenue.

Product based businesses:

Gross profit in a product business will look like this:

Sales revenue                                                          $100 000

Less cost of sales:

  • Opening Stock         $20 000
  • Purchases                 $50 000
  • Less closing stock ($18 000)

Total cost of sales                                                  $ 52 000

Gross Profit                                                            $ 48 000 

Thus, using the example above:

Gross margin = gross profit/sales revenue, expressed as a percentage.

.                       = $48 000/$100 000 x 100 = 48%

One of the areas where I see business owners getting confused is where they buy their product for $10 and sell it for $20 and think that they have a gross margin of 100%. What they have in reality is a markup of 100% and a gross margin of 50%.

Sale price                              $20

Less cost                               $10

Gross margin = $10 / $20 x 100 = 50%

 Example 1:

I’ve recently been working with a building supply company that has multiple product lines. Like so many product based businesses they import products from overseas, so they have the complication of foreign currency fluctuations in their costs. By implementing an inventory system, and ensuring that the data is accurate, they now have the ability to check their gross margin on the sales of each product line.

In delving into this level of detail, they have identified the product lines that have the highest gross margin and those with the lowest. The owners were shocked at how low the margins were on some of their product lines as they had been looking at the markup percentages and thinking they were doing well. They’ve now increased their sales prices for the lowest gross margin product lines and are seeking more sales of those with the highest.

I have no doubt that in six months’ time their overall gross margin across all product lines will have increased and they will have increased the profit of the business significantly.

 Example 2:

When I first met Cathy, who owns a floristry business, she had no idea about her numbers. Her accounting system wasn’t set up to provide her with management information, and she had no idea about gross profit let alone gross margin. Whilst talking with her she identified a couple of areas in her business that were key to her future success. One of these was her flower costs.

Over the ensuing twelve months, Cathy focused on her flower costs. She knew that her costs were too high for the price she was selling her bunches for and attacked the issue from a couple of different angles. Firstly, she focused on how much waste was occurring where she had to throw out damaged or wilting flowers. Every day for a month she kept track of the costs of the wastage. Armed with this information, she was able to buy more prudently making sure that she had sufficient stock but not so much that she threw money away at the end of each day and week.

She then looked at the way she bought her flowers and found ways of buying more cheaply without compromising the quality of the end result. After working on this for twelve months, she had reduced her flower costs by 22%. This meant an increase in her profit without having to sell a single extra bunch.

These aren’t Cathy’s numbers, but to give you an idea of what this could mean for your business:

.                                         Before                    After

Sales                              $100 000             $100 000

Less cost of sales:

– Flower costs              $  50 000             $  39 000

Gross Profit                   $  50 000             $  61 000

Gross Margin                 50%                         61%

 In summary:

Beware using markup figures when looking at your sales results. Make sure that you are looking at the gross margin and working on increasing it whether by increasing your sales prices or reducing your costs. If you’re selling multiple products, it is important to have detailed information on each product line to make sure that you’re not throwing away good gross margin on some products with poor or negative gross margin on others.

By focusing on improving both gross profit and gross margin, you will increase your profit and cash flow, and you may not need to be selling more or finding new customers to do so.

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