There are lots of great tools, rules, and accountants to help businesses complete and analyze profits, sales, and costs. Unfortunately, this is an area where clients frequently throw out the baby with the bath water. They often fail to use Gross Margin Analysis. Most business people understand the basic rules surrounding Gross Margin. They just don’t execute them.
Gross profit calculations are best made by item, by category, by customer and many other variables, each of which may be critical to your success.
Gross profit—or “Gross Margin” is simply calculated by the following equation:
Gross Profit = (Sales – Costs) / Sales
For example, if you sell a pair of shoes at retail for $100 and they cost you $30 to produce, your Gross Profit is equal to ($100 – $30)/$100 or 70%. Each industry has standards for Gross Profits that must be met in order to have enough cash flow to meet payroll and other operating expenses.
Accountants frequently accelerate the problems by focusing on accounting statements rather than the details that impact the statements. This has been evident in several recent meetings with clients. The meetings started with a client perception and strategy that they made a 60-70% gross margin. When the financials were reviewed, however, the actual sales margins was 10-20% less.
Some key general examples were:
Underestimating or forgetting costs like shipping, supplies, overhead, or labor.
Setting list prices and then giving key customers 10-20% discounts. This is particularly an issue with small growing clients that obtain much of their growth from accounts such as chains, Amazon, eBay, etc.
Gross margin assumptions based on proprietary products when 50% of sales are in commodity items with 15-20% lower margins.
Pricing on what new businesses think a venture capitalist wants to hear rather than who the competition is and how they can compete with them.
There are also at times issues surrounding cash versus accrual/capital cost as they relate to receivables, inventory and investments that require reconciliation.
Possible Solutions or Approaches
Here are a number of simple suggestions to help better comprehend these issues:
Many companies use business tools such as QuickBooks or Peachtree which can be used to compare actual financials with the strategic goals to determine reality.
You can develop product line merchandising plans that help analyze margin differences and their impact on gross profit as your business changes.
From the merchandising plan, you can compute customer profitability to determine who you are making money from and what customers you should really hug.
Hiring an objective outside accountant (not just a bookkeeper) is generally a good idea. He/she can analyze the information and ensure an objective perspective.
These issues can be critical in understanding the potential success of a business. They are even more important, however, in identifying opportunities and challenges. For example, gross margin can be a key determinant in evaluating the potential of various marketing and distribution programs.