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Gross Margin: What You Need to Know to Avoid Disaster

Gross Margin-What You Need to Know to Avoid DisasterGross 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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breakeven analysis

When Can You Expect a Profit?

In business, making good decisions is often the difference between success and failure.  Do you rely on gut, numbers or maybe a combination of both?  There are a lot of tools to help, but one of my favorites is a breakeven analysis.

What is Breakeven Analysis?

Breakeven analysis is used to determine when you will be able to cover costs and begin to make a profit from your business investments.  You may have used it when starting your business to determine how much sales or revenue you needed to cover your fixed costs or overhead.

It’s helpful before starting a business.  It’s just as important as your business grows and projections are replaced with reality — actual numbers. But it’s also helpful when making decisions on a variety of issues – Should I:

  • Invest in a marketing campaign, website or social media marketing?
  • Hire additional staff to support our growth?
  • Outsource a project or task to free up my time for important growth initiatives?
  • Purchase a new piece of equipment?
  • Upgrade our computers or phone systems?
  • Invest in technology to support growth?

While ROI is often used for many of these decisions, you can also use a breakeven analysis to answer the question “When will I begin to make a profit from this investment”?

How to Calculate Breakeven

To do a break-even analysis, you need to know two things. First, the cost associated with your investment decision. Second, your gross profit margin (%).

To calculate the break-even revenue, divide the cost by the gross profit margin percentage.  For example, if cost is $5,000 and your margin is 45%, your break-even revenue is $5,000 / .45 or $11,111.  In this case, you will begin making a profit when you hit $11,111 in sales.

For help calculating gross margin, check out my blog post, Gross Margin: What You Need to Know to Avoid Disaster.

How Many Customers Do I Need?

Clients also find it helpful to look at the break-even point from a number of customers perspective.  You can do this if you know (or calculate) the average dollar sale or transaction for your customers.

To determine the customer break-even number, simply divide the revenue break-even (above) by the average transaction amount.  Example:  If the average customer sale for the above business is $283, the customer break-even is $11,111 / $283 or 39.3 (40) customers.

Decision Time

Once you calculate the breakeven, it’s decision time.  Here are a few questions to ask yourself:

  1. Is the breakeven reasonable and achievable based on the investment you are making?
  2. If the incremental sales include new customers, what is the potential lifetime value of these new customers?  How does this impact your decision?
  3. How does this investment compare with past initiatives or others you may be considering now?  Business is often about trade-offs and priorities.

Knowing when you can expect to see a profit can be a powerful decision-making tool.  Use a break-even analysis to help you figure it out.

Ready to Put Your Business on the Path to Success?

Would working with a business coach help you take your business to a whole new level? Then let’s explore the possibilities with a complimentary consultation. It’s a chance to get to know each other, discuss your goals and the obstacles that hold you back. Together we can determine if there is a good fit between your needs and my services.

To learn more or schedule an appointment, call me at (856) 533-2344 or drop me an email

financial gross profit

Markup vs. Margin – The Difference Can Cost You

Your gross profit margin is a critical key performance indicator for overall net profit. Yet is is misunderstood by some small business owners.

Your gross profit represents what you have left over from sales (revenue) after you take out the variable costs – those that increase or decrease based on sales volumes.  These are often referred to as cost of goods sold (COGS) or cost of sales —  and it applies to all businesses.

  • If you sell products, like retailers or distributors, your variable costs include inventory.
  • If you make products, like manufacturers, your costs include raw materials and labor associated with production.
  • If you sell services, the costs include the labor associated with service delivery and may also include supplies required to do this.

Do you know your gross profit margin and how it compares to your industry? If not, take a few minutes to calculate it – divide your gross profit dollars by the sales/revenue for the same period. Please note that some small businesses include the above costs with expenses (versus the cost of goods sold). Talk to your accountant to make sure your costs are set up appropriately.

Demonstration: Markup Vs. Margin 

Are you surprised? Many small business owners are. And here’s the most common reason why. They use markup to calculate the selling price and assume the markup percentage is their gross profit margin. Ouch. They are not the same.

In fact, if you mark up your products or services 30%, your gross profit margin on this product or service is actually 23.1%. Below is an example to demonstrate this.

  • Your cost for your product or service is $100
  • You mark it up 30%  so your markup (or gross profit $) is $30
  • Your selling price (cost + markup) is then $130
  • Your gross profit is $30 – note the markup dollars and gross profit dollars are the same
  • But, your gross profit margin (gross profit $ / selling price) is 23.1%

I am not an advocate of using markup exclusively to establish selling price because it often ignores things like value and competition. But if you do use this method, be aware of the difference and start backward. Determine your DESIRED gross profit margin, then calculate the selling price required to achieve it.

BONUS: For a quick markup and margin calculation and conversion tool, click here.

Ready to Put Your Business on the Path to Success?

Would working with a business coach help you take your business to the next level of success? Then let’s explore the possibilities with a complimentary consultation. It’s a chance to get to know each other, discuss your goals and the obstacles that hold you back. Together we can determine if there is a good fit between your needs and my services.

There no obligation, only opportunity. So call me at (856) 533-2344 to learn more or schedule an appointment.

business woman speaking with tin can

When Your Gross Profit Margin Speaks, Do You Listen?

Your gross profit margin is a critical financial metric as it directly impacts your overall income.  For most businesses, this number remains relatively constant from month to month.  By tracking it monthly, you can easily identify issues before they become major problems.

Whether your margin is higher OR lower than normal, it’s speaking to you.  It’s giving you a red flag that says something is different or possibly wrong.  Do you ignore it or assume it will fix itself next month? Or do you investigate by digging a litter deeper or asking questions?

Is Your Change In Gross Profit Margin Explainable?

If you implemented a price increase, without an increase in cost, then you should expect an increase in your profit margin.  No problem, it’s explainable.

There are other reasons why you may experience a one-time blip in your margins – up or down.  You may not always like it, but again, they are explainable.  You know why it happened.  For example,

  • Did you have a few new customers with large sales, but lower than normal margins?
  • Did you have an extra pay period that increased your direct labor costs?
  • Did you need to purchase additional inventory or stock to meet a future need?

But you could also have lower gross profit margins because …

  • Suppliers raised or changed prices and you haven’t passed it on to customers or built it into your estimates or quotes
  • Quality issues caused work or jobs to be re-done or rejected
  • Customers were billed improperly or not at all
  • Supplier invoices for stock or materials were incorrect or paid twice
  • Labor hours are higher while sales are declining; scheduling more people than needed
  • Subcontractor costs were higher than you projected

These sometimes get ignored until they become obvious – your checking account is low on cash!   But the sooner you catch them, the sooner you can fix the problem.  So if you are not calculating or tracking GP margin, start now.

Related:  Markup vs. Margin:  The Difference Can Cost You

And when you uncover an issue, don’t ignore the red flags or band-aid the problem.  Fix it permanently by improving your systems and procedures – so it does not happen again and again.

Ready to Put Your Business on the Path to Success?

Would working with a business coach help you take your business to a whole new level? Then let’s explore the possibilities with a complimentary consultation. It’s a chance to get to know each other, discuss your goals and the obstacles that hold you back. Together we can determine if there is a good fit between your needs and my services.

To learn more or schedule an appointment, call me at (856) 533-2344 or drop me an email


Financial Ratios: Simple Tools For Better Business Decisions

Great products, marketing, sales, teams and operations certainly play a role in your success – but one thing is equally vital to sustained growth … understanding your numbers!

No you don’t need to be an accountant and well versed on debits, credits and a lot of financial information. But you do need to have a working knowledge of your income statement (profit & loss), balance sheet and cash flow statement – along with some financial ratios to help you make better decisions, identify trends and uncover opportunities!

There are a variety of financial ratios used to evaluate activity, efficiency, investments, leverage, liquidity and profitability. Relax, I’m not going to bore you with all of them! But here are a few common ones I use often with clients, just to get you started.

Current Ratio (also known as Liquidity and Working Capital Ratio)

This ratio measures your ability to pay short-term obligations. In other words, do you have enough current assets to cover your current debts or liabilities — current being the operative word here. Current assets include cash plus receivables and inventory that can be turned into cash within a year. Current liabilities are those debts that are due within a year, such as supplier payables, credit cards, payroll taxes, etc.

The current ratio can give you a sense of efficiency and measures your ability to turn products or services into cash. Long inventory turnover cycles, poor collection of receivables and inefficient use of labor can contribute to liquidity problems and poor current ratios.

The ratio calculation is Current Assets / Current Liabilities. The higher the ratio, the more capable the company is of paying its obligations. Anything below 1 indicates a negative current ratio, suggesting you may have problems meeting short-term debt obligations. While it is best to compare ratios by industry, a ratio between 1.2 and 2.0 is normally sufficient.

Here’s an example: Company XYZ has current assets of $23,400 and current liabilities of $17,300. Its current ratio is 1.35 ($23,400 / $17,300 = 1.35)

I also find trends helpful, so take a look at your quarterly balance sheet for the past few quarters and do the calculation. Are the ratios up, down or relatively the same? Why?

Here are some ways to improve this ratio for your business:

  • Collect on past due receivables – and grant credit wisely!
  • Accept credit card or online payments from your customers – make it easy and convenient
  • Use a system for billing – be consistent, be timely, be accurate
  • Have a system for collections – a series of scripts, emails and letters helps – be persistent.
  • Manage inventory – buy ‘just in time’ and get rid of obsolete stuff
  • Schedule deliveries / service efficiently to manage labor costs

Gross Profit Margin Ratio

This ratio shows your company’s financial health after Cost of Sales or Goods Sold are deducted from your Revenue (Sales). It measures your pricing strategy and operating efficiency. Your gross profit represents what is left to pay fixed expenses (like rent, insurance, administration,) along with owner’s compensation and future savings or investments.

Gross Profit Margin is (Revenue – COGS) / Revenue

Here’s an example. Company XYZ earned $5 million in sales while incurring $3 million in COGS related expenses, so the gross profit margin is 40%. ($5M – $3M) / $5 M. That means for every $1 earned in sales, the company has 40 cents in gross profit to apply to other expenses and future savings.

This ratio is a common benchmark used to compare a company with its competition. Higher efficiency and greater uniqueness (premium pricing) typically translates into higher gross profit margins. Optimum profit margins vary by industry, and are available through industry associations, online services and your local library.

Return on Investment Ratio

ROI is a performance measure used to evaluate the efficiency and/or profitability of an investment for comparison with other investment options.

Many are familiar with ROI as it relates to financial investments, such as stocks and bonds and real estate. But as business owners, this metrics is used to evaluate a variety of investments – equipment, hiring, education/training, and marketing to name just a few. And yes, marketing is an investment!

ROI is calculated as follow:

Gain From Investment – Cost of Investment / Cost of Investment = Return on Investment

Here’s an example. Company XYZ invests $1,500 on a new marketing program. They anticipate the effort will produce $7,000 in additional revenue. So the projected ROI is $7,000 – $1,500 / $1,500 = 3.66 or 366%.

One caution when it comes to comparison of ROI ratios. Be clear on what is included in the Gain and Cost elements and be consistent with your comparisons. In the above example, we defined the gain from investment as revenue, a common practice; but we could just as easily defined the gain on investment as gross profit from the additional revenue.

Here’s an example to demonstrate the difference. In the above example, assume that Company XYZ operates with a 40% gross profit margin. Then the gain on investment would be additional revenue ($7000) x gross profit margin (40%) or $2,800. The projected ROI is now $2,800 – $1,500 / $1,500 = .867 or 86.7%

There is no right or wrong method – just be consistent in your approach. When getting ROI ratio from others, be clear on the gain and cost elements they used!

There’s an old saying when it comes to measures of success – What we measure, we can improve. Start using these tools in your business – and put yourself on a path to better decisions and better results!

More Ways to Grow Your Business

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