Now that we’ve sussed what Direct Costs and Overheads are, let’s crack on with seeing how they can help us manage our small business!
The first metric we’ll look at in this series is the Gross Profit Margin.
What is Gross Profit?
It’s your Total Revenue minus your Direct Costs.
So, if you made £500,000 last year, and you spent £300,000 on your stock and materials (your Direct Costs), then your Gross Profit is £200,000.
That means you had £200,000 leftover for all your Overheads such as premises, staffing, marketing, insurance, etc, and for your profit.
What is the Gross Profit Margin?
Anytime you see the word “margin” in the name of a business metric, it almost always means it’s a percentage, or ratio.
As The Motley Fool says, “Margins are metrics that assess a company’s efficiency in converting sales to profits.”
This one’s quite straightforward: Gross profit / Revenue
Continuing with the example above, your Gross Profit Margin would be: £200,000 / £500,000 = 40%.
What is your Gross Profit Margin?
Right, now go grab your own Profit & Loss report (also called an Income Statement, or a Statement of Financial Activities).
Find the Gross Profit (usually about one-third down the page) amount and divide it by the total Revenue (usually right at the top). That percentage is your Gross Profit Margin.
What does your Gross Profit Margin tell us?
The Gross Profit Margin tells us how efficiently your company controls its production costs. Hopefully, a higher gross profit margin leads to more profit on the bottom line, but that’s not always the case.
Using the margin (%) instead of the money (£) is really useful if you’ve experienced a lot of growth or contraction over the years.
Let’s say last year your sales were £100,000 and your Direct Costs were £40,000, then your Gross Profit Margin was 40% last year, too.
Knowing that means that when you look at your profit & loss report, you’re not focusing on the sticker shock that your Direct Costs jumped from £40k to £200k as though it’s a worry. You know that actually, your efficiency in controlling your production costs has stayed the same, despite your rapid growth – which is an amazing achievement, well done!
This is a metric mostly focused on by product-based businesses, since they’ll spend most of their revenue on the stock they sell (whether they buy for resale or whether they buy materials and labour to turn it into finished goods).
However, some service-based businesses may have sizeable Direct Costs. For example, a trucking firm may choose to put all its drivers’ wages under Direct Costs, which would be a sizeable portion of its expenses. In that case, the trucking firm would want to pay attention to its Gross Profit Margin.
What is a good Gross Profit Margin?
Higher percentages are better for this metric.
But what’s a good one? It depends.
A service-based business will always have a much larger Gross Profit Margin than a product-based business.
- A dog walker will have minimal Direct Expenses – perhaps just payment processing fees from their clients. This will lead to a high Gross Profit Margin.
- Some accounting firms I know include their software subscriptions as Direct Expenses. These can be quite dear, so even though it’s still a service-based business, they will have a lower Gross Profit Margin than the dog walker.
- A manufacturing firm will have very high Direct Expenses – most of their revenue will be spent on materials and labour to be made into finished goods. Their Gross Profit Margin will be much, much lower than either the dog walker or the accounting firm.
But even within a specific industry, it’s difficult to compare between companies. As I mentioned last week, different companies will make different decisions about what constitutes a direct cost and what doesn’t.
How can you use your Gross Profit Margin?
What’s much more useful and dependable than comparing against other companies or industry benchmarks is comparing:
1. Your past quarters and years
Try to improve your Gross Profit Margin each quarter and year.
If it decreases, know that you’ll need to find savings out of your Overheads to compensate – or profit will suffer.
If your Gross Profit Margin increases over time, your company’s operations are said to be becoming more efficient. If it decreases, they’re becoming less efficient.
2. Different products, product lines, or arms of your business
When weighing up whether to launch or continue with a product, it’s incredibly illuminating to check its Gross Profit Margin (or expected) against your other products.
It can be difficult or impossible to split your Overheads across your products, product lines, or arms of your business. The Gross Profit Margin is ideal for comparing these because it doesn’t take your Overheads into consideration.
Comparing distinct parts of your business and over time is where your management accounts truly start to help you manage your business effectively.
How can you improve your Gross Profit Margin?
Since not many items go into this calculation, there aren’t many ways to alter this figure. Indeed, there are really only 2 levers for this:
1. Pay less for your materials (or stock) and direct labour
Here are a few ideas for how to do this:
Negotiate bulk discounts with your suppliers
If you have the cash and the warehouse space, then place larger orders less often to take advantage of bulk discounts.
Find cheaper suppliers
Check for cheaper options for your materials and stock
Hopefully, you already have an SOP in place to routinely check the market for cheaper suppliers, so that you don’t end up paying more than you need to through inertia.
Consider cheaper options for your direct labour
Your direct labour is made up of those employees involved directly in producing your products.
This lever is what’s led to so many factories being moved out of countries like the UK and US to countries like Turkey and Mexico. It’s easy to get so fixated on your ratios and bottom line that you forget the bigger reasons behind why you started your business.
There are other ways to pull this particular lever, though:
You could consider hiring apprentices and other lower-skilled workers for part of your operations. This won’t work for everyone, or for all your operations. But it might be practical sometimes.
You could invest in a time and motion study. This is often used to reduce the number of employees needed, but you could also use it to increase output (and thus sales).
Eliminate unnecessary costs in producing your products
Consider whether all your packaging is purposeful.
Cutting any unnecessary packaging will reduce the weight and may reduce your carriage outwards costs (your freight or courier costs to get your products to your customers). Plus, you can stop buying it, so it’s a double win!
Unboxing experiences can be especially important, so I’ve phrased this carefully: it’s not about whether any packaging is unnecessary, but that it’s all thought through and being used on purpose. That tissue paper may not be strictly necessary, but if it helps the customer feel like they’re unwrapping a gift, then they’re more likely to buy again, so it’s worth the expense.
Get free shipping from your suppliers.
If you’re paying for carriage inwards on your stock (delivery from your suppliers), you could try to negotiate with your suppliers for free shipping (perhaps in tandem with discounts for bulk orders). Or it may prove cheaper if you could collect (it may not, so consider carefully).
Check that every part in your product is necessary.
My husband is an enthusiastic fan of Big Clive’s YouTube channel. Big Clive routinely takes apart electronics. Watch enough of these, and you see the pattern: the Chinese knockoffs will start with all the same components as the name brand product they’re copying. Then, gradually, they’ll drop parts one by one. If the thing still looks like it’s doing what you want, they’ll sell this stripped-down version.
Some parts add a touch of class or elegance, to be sure; if it’s not off-brand, you could consider getting rid of those to create a budget version of your product.
However, many parts are there for safety reasons, so of course, you wouldn’t exclude those.
2. Raise your sales prices
You must do this with care, of course, to stay competitive.
Consider creating a luxury version of your product
That would be a big project, of course, and is not to be jumped into quickly. But margins are generally higher on luxury goods, so if it could work for your firm, it’s definitely worth exploring.
Consider creating a luxury version of your service
Creating a gold or VIP tier can quickly give you a luxury version at a higher price point to promote. Limit the availability, though, so you don’t end up stretched too thin!
Conclusion
In this blog, we’ve looked at:
- What the Gross Profit is
- What the Gross Profit Margin is
- What it tells you
- What to compare it to
- How you can improve it
Hopefully, you’ve spotted at least one action point to take away and apply today in your own business.
Jump to the next post here:
Hi, I’m Sara-Jayne Slocombe of Amethyst Raccoon. I help your small business thrive using the power of your numbers, empowering you so that you have the confidence and knowledge to run your business profitably and achieve the goals you’re after.
I am a UK-based Business Insights Consultant, which means I look at your data and turn it into information and insights. I separate the noise from the signal and translate it all into actions that you can actually take in your business.
I also facilitate the Power Pod Roundtable, which is a business discussion group.
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