Gross profit margin is one of the most important metrics in your business. It can make or break a company because it impacts how you price your products and make a profit. Here’s what you need to understand to avoid costly mistakes and build sustainable profit.
What is Gross Margin?
Gross profit is the money that is left after you have covered all the variable costs associated with the sale of your products or services. Depending on the type of business, these expenses (sometimes called COGS or COS) include direct labor or wages, raw materials, supplies and inventory.
And since your gross profit is needed to pay your fixed or overhead expenses and YOU in wages or draw, it is worth knowing and monitoring.
How to Calculate Gross Margin
Using historical data for one year (or one business quarter), identify total Revenue (or income) and COGS (variable costs) for the same period. To calculate gross profit margin:
- Revenue (Sales) minus COGS (Variable Costs) = Gross Profit $
- Gross Profit $ divided by Revenue $ = Gross Profit Margin (%)
Here is an example.
- Revenue ($600,000) minus COGS ($320,000) = Gross Profit ($280,000)
- GP ($280,000) divided by Revenue ($600,000) = GP Margin (46.7%)
Once you know what your historical margin is, calculate and monitor it monthly or quarterly to identify any swings, negative trends or potential problems. For example, if your historical margin is 46% and your current margin is 41% you have a red flag – something is potentially wrong. Margin changes may not always be so obvious. They may consistently trend downward (45%, 44%, 43%). Do some checking. Why wait until it hits 39%.
Why Margins Fluctuate or Decline
While this may vary by type of business, here are some common reasons why your gross profit margins may fluctuate or decline:
- Discounting products or services – this is killer!
- Overtime pay or wages for direct labor employees due to staffing issues
- Vendor price changes (materials, supplies or inventory) without adjustment in selling price
- Theft by employees, customers or both
- Inefficient service delivery or manufacturing – higher than expected labor costs
- Improper invoicing to customers or non-payment by customers
- Incorrect or duplicate payments to vendors for materials (yes I have seen this!)
- Product mix changes. Replacing high-margin sales with low-margin sales
- Incorrect assumptions on variable costs – especially labor and materials.
Knowing your gross margins for all your products or services and monitoring them as your business grows will help you identify problems before it is too late and help you uncover some hidden opportunities to improve them!
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