Gross Margin – The Pivot Point of Business Math

by Shaun R Smith on April 6, 2010

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If you read my article from last week on the importance of budgeting and the challenge of revenue forecasting, you’ve hopefully taken the first step: you’ve examined last year’s performance and set some revenue projections and goals for your business going forward.  The next step is figuring out how much it’s going to cost you to deliver your product or service – and how much of that you’ll get to keep.

The basic formula for this portion of your budget (if projecting forward) or profit and loss or income statement (if looking backward) is:

Total Revenue (also called Total Sales, Gross Revenue, Top Line)

- (Minus)     Direct Costs (also called Variable Costs, Cost of Goods or Services Sold)

= Equals     Gross Profit (Gross Profit Margin = Gross Profit/Total Revenue)

In general, your company’s direct costs will be a percentage of your total revenue.  It might vary widely by product or service type, but should be rather consistent over time.  It is a function of your value added, competitive positioning, brand equity, and cost to deliver – the main elements which determine your pricing power.

To complete this line of your budget, you will calculate your percentage of direct costs per item type sold.  The easiest way to accomplish this is to use a spreadsheet.  Calculate your Revenue, Direct Costs, and Gross Profit per item.  Then sum them to incorporate them into your budget.

The Gross Profit is the difference of these two items.  It is what is left over per sale to go to cover your Indirect costs (or Overhead) and to generate your Profits.

Making a Profit

There are only two ways to lose money in business –

  1. By not delivering your products and services profitably per item or job or project.
  2. By not selling enough goods to cover your Indirect costs – not generating enough gross profit to cover your expenses and have a profit remaining.

Creating Gross Profit with Every Sale

While it may seem obvious that you need to make money on what you sell, there might be cases where you won’t.  You might intentionally decide to price a product or service of yours very aggressively to generate business and steal market share.  This practice of using a loss leader must be done very carefully so as not to drive down pricing for your entire market – and not to adjust consumers’ expectations of price and value down.

An inadvertent loss is even more dangerous.  This can occur when you have underpriced a project or job or service (usually because you have committed to a fixed price to the client, but your Direct Costs unexpectedly increased to a level higher than expected) or you are miscalculated or miscategorizing your Direct Costs.

Direct Costs are all the expenses that you can track or assign to a specific product or sale.  In a product based business, most of the direct costs will be the cost to your company of the goods or raw materials.  In a service based business, most of the direct costs will be composed of the direct labor expense to deliver the service.  If you run a hybrid business – it will include both elements.

Gross Profit Margin: What You Make Per Dollar

Your company’s gross profit margin tells you how much you keep per dollar sale amount that goes to cover your Indirect Costs and Profit.  For example, if you run a quick-service restaurant and you sell a hamburger, your numbers might look like this:

Total Sale:           $5.00

- Direct Costs:    $3.00 (includes cost of ingredients and direct marginal labor)

= Gross Profit:   $2.00

Gross Profit Margin = $2.00 (Gross Profit) / $5.00 (Total Sale) = 40%

If all your products had approximately the same cost structure and your gross profit margin were the same across your business, for every $1.00 in sales, you would get to put $0.40 towards your Indirect or Overhead expenses.  Whatever’s left after you cover your indirect costs is your profit.

To increase your Gross Profit Margin – you can either:

-          Increase your prices, or

-          Decrease your direct costs.

If you are able to decrease your direct costs without sacrificing quality, that is a great strategy to pursue in any situation.

Once you are successfully selling your products and services for a gross profit per sale, you must then make sure you are selling enough to cover your other expenses (the indirect costs for your business).  We will discuss that and break even next week.

Next Week – Indirect Costs and Break Even

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