How front of mind is the meaning of gross profit for most business managers. If asked to describe what gross profit is, they would invariably say it is sales revenue minus cost of sales. Of course that is correct, but what does it truly represent?
For me, it represents a measure of customer value created by the business in the reporting period. Another way of describing this is that it is a measure of wealth created by the business. As such, it is the most important measure for the business to focus on. Why do businesses exist? In the main, they exist to service a market, and the consumers in those markets that they service are their prospective customers.
As such, gross profit is the measure of how successfully they are performing their core functions. Their raison d’etre.
Now we should be clear on the specific language used here. Where I say that “gross profit is the measure of customer value (wealth) created”, it is important to focus on the word “created”. Revenue is the measure of monies received in exchange for the customer value provided by the business. Cost of sales is the measure of the component of customer value that was purchased by the business. As a result, gross profit represents a measure of the “value or wealth created”.
The question then arises as to whether there are implicit, or unmeasured elements of value that are created but are not captured in the gross profit measure. The answer to that is a very clear yes.
I have described some of these here but first there are a couple of points that need to be understood.
- The gross profit as measured by a business could better be described as the “customer value created and captured by the business”
- The cost-benefit relationship will determine which implicit costs the business should seek to capture
The implicit costs that detract from the customer value created as measured by gross profit include the following.
There are many causes of pricing inefficiency. These include:
- One price, many clients – consumers gain different levels of utility from a purchase even though they have paid the same price
- Market power costs – customers with real buying power can negotiate lower prices (below their value received)
- Perception costs – poorly packaged or poorly articulated value propositions may result in lower prices being achieved (to match the lower levels of perceived value)
- Input costs – these can vary due to many reasons such as volume buying, exchange rates, securing supply, quality differences or supplier market power. These can all affect the cost of these inputs
- Productivity – whether manufacturing, retailing or supplying services this will have a big impact on costs
- Waste – the cost of non-productive resources, quality failures or underutilised capacity are among the key waste costs
All of these inefficiencies result in reducing the amount of value created that is actually captured by the business.
Businesses rise and fall on how well they can create wealth (operations) and how well they can communicate this (sales & marketing) within their chosen markets. The key message here is that the gross sales revenue is not the most important measure. Wealth created is the critical measure for all businesses.
At 3S CFO Group we work with a range of businesses to provide management reporting and analysis frameworks to focus on growing the measure of wealth created by those businesses.
Colin Wright is the managing director of 3S CFO Group
3S CFO Group is a member of the Association of Virtual CFOs