Business Basics: Gross Profit and Gross Profit Margin

Every business owner must know how to organize his/her revenues and expenses. Why? It will improve his/her odds of success.

Take the analogy of the golfer. Why hold the golf club a certain way? Well, you can hold it any way you want, but over hundreds of years golfers have tried virtually every technique conceivable, and the best results are generally garnered from one particular grip.

The same concept holds true for the financial management of a business. You can organize the financial data any way you wish, but you might want to express your creativity elsewhere.

The accepted “best practice” for the organization of a business’ financial data has evolved and been refined over thousands of years. The concepts are embodied in what we call Generally Accepted Accounting Principles (GAAP).

Maintaining a Healthy Gross Margin Is Mission-Critical

Business owners and managers would also be wise to know which part of the income statement is the most important. That is: “Get this one thing right and you’ll be well on your way. Get this one thing wrong and you’ll have a very hard time ever finding success.”

This one thing is — the gross profit margin.

Keeping with the golf analogy, the universally accepted #1 swing tip is: Keep your head still. The “keep your head still” of business financial management is: Watch your gross profit margin. That is, make sure you earn a healthy margin. Don’t let it erode, and make sure you at least match what is earned by your most successful peers. Peer gross profit data can be obtained through your industry association.

Your Gross Margin Provides the Cash Your Business Needs

But to explain why the gross profit margin is so important, let’s use some more analogies.

You run on food and water. Your car runs on gasoline.

Run out of food and water, you die. If your car runs of gasoline, it becomes worthless.

Your business runs on cash. It needs cash to buy raw materials, pay the rent and employ the employees who create the products and services, market and sell them, collect the cash and deposit it in the bank. A healthy business will generate more cash than it consumes. If it does not, it will die.

So the stream of cash that flows into your business is the gross profit. The higher the gross profit MARGIN, the larger the stream. The lower the gross profit margin, the smaller the stream of cash available to fund your operations and investment in future growth.

Revenue Is Important, Gross Profit Is More Relevant

One could argue that revenue is the most important number, but this is simply foolish. Every product or service you sell has expenses directly associated with it. Let’s say you publish books. For every dollar you take in from the sale of a book, you have direct costs in the printing, payment of author royalties, salesmen or broker commissions, shipping fees, etc. So the only relevant number is the profit (cash) that remains after the direct expenses are paid. Right?

The gross profit is all you get to keep to pay the rest of your bills (i.e., operating expense, also referred to as sales, general and administrative expenses). You don’t get to keep revenue; just what’s left over after you’ve paid the direct expenses you incur in the production, sale and delivery of the product or service.

The gross margin is the ratio of gross profit to revenue. For example, if you make $50K gross profit on $200K in revenue, your gross margin is 25% ($50 divided by $200). Of course, this would mean your direct expenses (i.e., cost of goods) were $150K.

Revenue — Cost of Goods Sold =   Gross Profit
Gross Profit / Revenue =   Gross Margin
Example: $50,000 / $200,000 =   25%

Gross Profit Margin Drives Bottom Line

To further drive home the critical nature of the gross profit margin, let’s take a look at how changes in the gross margin impact the bottom line. Take a company that has a 40% gross profit margin (i.e., cost of sales takes 60% of revenue) and a 10% operating profit margin (also referred to as pretax profit) — a healthy income statement by most standards.

Now let’s say that the owner fails to closely manage his gross profit margin and, either through a rise in cost of goods or a lowering of the price they get for their products or services, gross margin dips from 40% to 34%. This 10% increase in the cost of goods reduces operating profit by 60%. Here’s the math with percentages:

Pre($) Post($) % Change
Sales $100 $100
Cost of Goods $(60) $(66) 10%
Gross Profit $40 $34 (15%)
SG&A $(30) $(30)
Operating Profit $10 $4 (60%)

The lessons?

  1. Without a healthy gross profit margin, bottom line profit is almost impossible.
  2. A small erosion in gross profit margin can wipe out bottom-line profit.

Sell Quality, Not Price; Wring Direct Costs Out

How does one manage gross profit effectively? Unfortunately, there’s no magic potion. It’s just a matter of:

a.      resisting the temptation to win sales by lowering prices.
b.      wringing direct cost out at every turn.

It’s very hard to run a profitable company by competing on price. Only the firm with the lowest cost structure can win with such a strategy. The low-cost strategy is typically viable only for the firm with the highest volume, and virtually every industry has a firm that competes on price. To succeed, they must go for volume, “no frills” service and merely “acceptable” quality. The only logical and viable competitive strategy for the firms with lower volumes (most everyone) is to offer higher levels of quality and service at higher prices — prices that will more than offset the added expense incurred in the delivery of the higher levels of product and service quality.

Just a Few Low Margin Sales Can Devastate Overall Profitability

Business owners should also keep in mind how sensitive the overall profitability of the business is to the profit margins earned on individual sales. That is, the impact a few money-losing products and services can have on a company’s overall profitability. To illustrate, let’s look at a consulting firm that has 20 types of consulting projects. Peerless Consulting tracks the labor hours and direct costs required to deliver each of its project types. Peerless also knows the income that each job brings. Here’s the simplified 2008 data:

  • Total annual revenue was $1,000,000.
  • Each of the 20 project types generated $50,000 in revenue.
  • Fixed overhead costs were, and will continue to be, $205,000 per year.
  • Operating profit was a negative $5,000.

A look at the data revealed that two of the 20 project types lost money. In fact, the money-losing two together cost $50,000 more than the $50,000 in income they generated (i.e., together the two products brought in $100,000, cost $150,000 and therefore lost $50,000). If Peerless were to eliminate these offerings altogether and the labor associated with the delivery of such projects, revenues would decline to $900,000, but operating profit would increase from negative $5,000 to $45,000 in the black. Here is the comparison.

Income Statement — Peerless Consulting

2008 Actual Pro Forma
Revenue $1,000,000 100% $900,000 100%

Cost of Goods Sold

$800,000 80% $650,000 72%
Gross Profit $200,000 20% $250,000 28%

Fixed Expense

$205,000 21% $205,000 23%
Operating Profit ($5,000) (5%) $45,000 5%

By simply eliminating 10% (two of the 20) of the project types and 10% of overall revenue, Peerless becomes a profitable company at a respectable operating profit margin of 5%. If fixed expenses could also be reduced, then the bottom line would rise dollar-for-dollar and the operating profit margin would increase sharply.

Now, another alternative would be for Peerless to find a way to keep the two money-losing offerings but make them profitable. The average gross profit of the 18 profitable offerings is 28%. If we assume that the two losers could also earn 28% or $14,000 gross profit each, then Peerless’ Pro Forma Income Statement would look like this:

Revenue $1,000,000 100%

Cost of Goods Sold

$720,000 72%
Gross Profit $280,000 28%

SG&A Expenses

$205,000 21%
Operating Profit $75,000 7.5%

By turning around the two money-losers, Peerless’ operating profit has increased to a respectable 7.5% margin. And that, compared to a net loss, makes all the difference in the world.

A small number of money-losing products or services can have a devastating impact on the overall profitability of a company. Peerless lost money in 2008 though 90% of its products were profitable!

The lesson: Analyze your per-product profitability. Use the information to create profitability across your entire product line. The impact of losers is too great to ignore.

In conclusion, the business world is complex, but business management, at its heart, is pretty simple. To manage and grow a profitable business, your most important task is to find ways to sell more and more at healthy profit margins. The most critical number is the gross profit margin. Deliver a consistently healthy gross profit margin and the rest of your job will be a heck of a lot easier.

This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2016.

This publication is intended to provide general information on the subject matters covered. It is sold and distributed with the understanding that neither the publisher nor any distributor or advertiser is engaged in providing legal, tax, insurance, investment or other professional advice. The advice of a qualified professional should be sought before any reader applies a concept presented herein to his or her particular situation or business.

D.L. Perkins, LLC is solely responsible for this content.

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