What you need to know about Gross Profit Margins
Gross Profit margins are a critical metric that every entrepreneur needs to be on top of. It’s a make or break metric for every business, irrespective of your industry.
Most entrepreneurs think they know their Gross Profit margins – but from our experience, most don’t measure it accurately, which can have dire consequences.
In this video, Jason shares how to accurately calculate your Gross Profit and best practice tips on how to improve your margins.
Gross Profit margins are a crucial metric that every entrepreneur should be measuring in their business. The purpose of measuring your gross profit margins is to give you an understanding of the profit you make at a product level. So basically – when you make a sale, what’s the profit after all the attributable costs are deducted from that sale.
Now it’s super important to measure Gross Profit because you want to understand what profit you’re making at a product level so you ensure you have enough remaining profit to reinvest back in your business, into marketing, sales, making sure your staff are happy – all that good stuff.
How’s it calculated?
Your Gross Profit margin is calculated as your sales less your cost of sales. It’s typically expressed as a percentage. To get your percentage it’s simply your gross profit dollars divided by the sales for the period you’re looking at.
What’s in Cost of Sales?
Service based industries
If you’re in a services based business – say if you’re a digital agency or an accounting firm – your product is the people behind it i.e the people that actually doing the work.
It’s important that you attribute any wage costs for your revenue generating employees to cost of sales. This gives you a better indication of the margins you’re making at that level.
Product businesses
If you’re an eCommerce business or inventory based business, you need to attribute all the product costs to cost of sales. These include the raw goods, the shipping costs, your Ebay fees etc.
All costs that are attributable to getting the product in, buying it, and shipping it out should be allocated to cost of sales.
Software as a service business
As a minimum – your hosting costs should be included in the cost of sales lines.
There’s a debate as to whether customer success costs (wages for your customer success team) should be moved up to the cost of sales line. Our view at SmartBooks Online is that they should allocated below the line under Customer Acquisition Costs. This is because customer success teams are essentially like sales people. They help to reduce churn, and delight your current customers so they can go on and refer more clients to you.
Best Practice
1. Review monthly financial statements monthly
In your head you should know what profit you need to making or what dollars you need to be selling at to make adequate gross profit. Your salespeople need to be educated on this.
Every month you should be looking at your financial statements and reviewing the Gross Profit levels you’re making in business. So financial statements – review them monthly at least.
2. Quality bookkeeping
Because the cost of sales value is so critical to the gross profit calculation, it’s important you have your chart of accounts correctly set up.
Examples include – ensuring you are attributing your revenue generating employees to cost of sales, ensuring your shipping costs allocated to cost of sales.
If you have all your costs coded to one account (“general expenses” is a popular one…) you have zero clarity on your gross profit margins.
How to improve your Gross Profit margin
1. Increase your prices
You’d be amazed at the results of simply increasing your price, even as little as 3% or 5%. To the customer, it may not seem a lot, but it all adds up at the bottom line and can be significant.
2. Reduce your cost of sales
Look at ways you can try to reduce your costs at the product level.
These include constantly reviewing supplier lists to ensure you’re getting the best deals in the market. You can look at joining group buying arrangements so you can get bigger discounts through economies of scale.
3. Review your product mix
If you’re like most business, we have a range of services or products to sell – and some products will have a higher profit margin than others. It’s really important to have the data to understand what products are more profitable to your business, and which are the lower profitability items, and then understanding the mix of those.
To score some quick wins, you can look at increasing the volume of your higher-margin products compared to your lower ones, which will give you a greater profitability margin at the end of the day.
4. Review your inventory balance
Constantly review your stock balances to ensure you’re not carrying anything that’s obsolete. Carrying stock impacts profitability and working capital so the less of it the better!
So that’s it on Gross Profit margins – I hope you got some value out of this video. Feel free to reach out if you need any help determining yours. Otherwise we’ll see you next week for another episode.
