Gross profit margin – The elephant in the room
Do you fully appreciate the importance of gross profit margin (GPM) in your business? I am sure you do, but let me test you on this. For retailers and wholesalers measuring GPM is not so difficult. However, if you run a manufacturing, jobbing or service delivery business, measuring GPM can be very difficult.
In fact, without well set up business management systems and skilled financial management resources it can be just too hard. So the question about whether you fully appreciate the importance of GPM to your business could be reframed to ask “are you prepared to invest in managing the most important cost in your business?”
For many businesses their COS (cost of goods sold or cost of services delivered) can be around 70% or more of revenue while overhead costs are around 20% (some companies such as con-tract manufacturers can have cost of sales as high as 80% of revenue. In general, this means that COS can be 3 to 4 times higher than overhead costs.
If it is around 4 times larger than overhead costs, do you put 4 times the effort into understanding precisely what GPM you are achieving?
Do you have the systems to measure GPM? Getting accurate measures of GPM is complex and often unachievable without good systems. An experienced CFO can help you to get these systems in place.
Understanding your performance levels quickly after the end of each reporting period allows for powerful decision making that drives improved performance outcomes. Good systems and strong disciplines are key to achieving this. Once again, an experienced CFO will automatically bring this focus to the business.
If you are not investing in the management of your GPM, you need to do so. It is an investment on
which you will get a very healthy return.
Now that you have accurate and timely GPM figures, what do you do with them? You will need to analyse why the GPM outcome is what it is? Was your variance to budgeted (or targeted) GPM caused by a product mix outcome, a customer mix outcome, changes to input costs, productivity changes, waste levels or other causes?
An experienced CFO will provide these reports. You will then know what the priorities are in your business. Focus on strategies that make a real difference and not get caught working on things that make only a minor difference.
You can then make decisions on critical factors such as customer pricing, volume incentives, discontinuing low margin products/services, promotional strategies to sell more of the high margin products/services, focus on achieving lower input costs, and so on. All targeting improving your GPM and, as a consequence, growing your bottom line.
Do you pride yourself on running a lean ship? Be very careful that you are not in fact eroding the foundation of your business. Nearly every SME business runs its business with very lean overheads. But often they compromise the business’ capacity to deliver value to its customers. And often it compromises the business’ ability to produce its goods (or deliver its services) efficiently. This, in turn, increases the COS, usually by a much higher figure than the business has saved in overhead.
Overhead costs need to be seen as an investment. A business should only incur overhead costs to support efficient operations, customer support, administration, management decision making and business strategy. That is, it is an investment in operating the business successfully. The question should not be “how much can we afford”, it should be “what return will we get on this investment”. This can be complex, but it is common for us to see businesses compromise their GPM and business future by cutting their overheads too lean.