Do you ever wish that there was a magic number that would give you an insider view on your profitability? Do you wish that there was an easier way to take the pulse of your business’s financial health? Do you wish that there was one financial metric that you could use to help determine if you are moving your business in the right direction?
Gross Profit Margin
Sometimes I coach my clients about business, and I often sit down with new clients and discuss their financial pillars. Most can give me the basics about their finances, but nine out of ten business owners look a little clueless when I ask them about their gross profit margin. So let’s first begin by looking at what Gross Profit Margin is.
Gross Profit = “Total Sales” less “Cost of Goods Sold”
Your “Cost of Goods Sold” is your direct cost to produce or acquire to resell your product or service. It generally includes materials cost and direct labor costs. When you express your Gross Profit as a percentage of your total revenue, then you get your “Gross Profit Margin”. For example, if you were a business with $1 million in sales (total revenue) and a Cost of Goods Sold of $250,000, then your gross profit margin would be 75% ($750,000 gross profit divided by $1 million in total revenue.) In a very important way, your Gross Profit Margin is a simple measure of your ability to be profitable. If it is too low, what that is saying is that your price relative to the cost of producing your product or service is simply too low for you to ever be profitable. Remember, your Gross Profit only accounts for direct costs of producing your product or service, and not for any of the other costs of operating your business like sales, marketing, operations, admin, finance, let alone PROFIT for the owners.
How To Use Gross Profit Margin In Your Business
Once you have your magic number figured out, you can use it to make some really important decisions surrounding your business, such as:
If your gross profit margin is on the low side, one easy way to balance the equation is to raise your pricing. Most business owners put this task off for way to long, and it has a huge impact on your ability to scale and grow. Consider when the last price increase was, your value in the market and your competition and then raise your prices accordingly. My biggest tip here: Don’t try to be the cheapest out there, be the company that provides the most value for its customers.
2. Your Cost of Production
Cost of production is another problem area that a low gross profit margin can reveal. It can alert you of product lines that need to be discontinued or markets that you should ignore. You can also use this as a tool to approach your vendors and try to negotiate for a lower cost of goods in order to compete.
3. How You Stack Up Against The Competition
If your industry averages a 50% gross profit margin and you are operating at a 60% margin, then you know you are on the right track. If your gross profit margin is less than your industry average, consider making some changes to meet industry benchmarks. At the end of the day, your gross profit margin can tell you a lot about the health of your business and give you a clear cut plan on where you should improve for the future.