Okay, you get it. You need to achieve a targeted gross profit margin to ensure your business is financially successful and generates positive cash flows.
And you agree that regular reporting is the key to you being able to manage this critical measure. This will enable you to respond quickly whenever these margins fall below the target figure.
You just have one problem. The margins you are monitoring are all over the place. One month your margin is 43%, the next month it is 26%, and then it is something else again. What is happening? How will you know whether you are on track or not?
This is not an uncommon situation in small and medium sized businesses. Let’s look at what the main causes of this are:
• Inappropriate recognition of income and expenditure
• Incorrect valuations
• Misallocation of accounts
Inappropriate recognition of income and expenditure
This is generally a timing issue. For example, sales are recognised in the accounting period but some or all of the costs of sale are not recognised until the following month. In the case of project style jobs running across several periods there is often a mismatch in the timing of when income and expenses are accounted for.
Customer and supplier deposits can create recognition problems. Income should only be recognised when the product or service is delivered and expenses relating to those sales must be matched to when the income is recognised.
Many businesses sell vouchers and inappropriately allocate the income to revenue. Depending on the terms of the vouchers, these are generally liabilities (an obligation to provide a product or service in the future).
Businesses that sell subscription services or fee for services (multi-period) should only recognise the revenues as the services are delivered.
The most common problem in this area is incorrect stock or work in progress valuations. This can be due to incorrect stock figures or incorrect unit prices (e.g. freight and shipping may not have been capitalised). It could also be the case in project delivery where a partially completed project needs to be given a work in progress valuation to ensure the correct revenues and costs are recognised.
Direct labour is a key cost of sale. Once again, businesses need to recognise all of the cost of direct labour and not just the payroll figures. This requires accruals for wages to the end of the period. It also needs changes to employee entitlements to be recognised.
Misallocation of accounts
Many accounts sneak into the overhead expenditure area instead of in cost of sales. This may be service vehicle costs, trade tools and other direct costs. The question has to be asked as to what costs are incurred in the production and/or delivery of products/services.
Businesses need to be sure that they are capturing all cost of sale expenses in the cost of sales.
Trusted margins promote good decision making
Once your business is confident that all these issues are being accounted for appropriately, two critical outcomes will be achieved.
1. Your gross profit margins will be more consistent
2. Variations in the gross profit margins will actually be meaningful and require you to understand and respond to what is happening.
At this point you will be able to develop reliable strategies to improve cash generation in your business.
If this relates to your business and you cannot justify the costs of a full-time, experienced CFO you should consider a virtual CFO to help you improve the profitability of your business.