The Long and Winding Road to Financial Success: Increasing Your Gross Profit Margin
Face it—running your own business can be scary. You are at the whim of the market, which is a bumpy road filled with unpredictable hills and turns. What is the best way to make sure you’re prepared for whatever lies ahead?
Many small business owners have a simple answer to this question: increase sales. That makes sense, right? If you want to make sure your business continues to grow, you should sell more products or services this month than last month.
Well, it’s not that simple; since the market—and demand for your services—is so unpredictable, your ability to increase sales is never a sure thing.
Increased Sales Does Not Mean More Profit
Writing in the Harvard Business Review, Michael J. Mauboussin, the managing director and head of Global Financial Strategies at Credit Suisse, recounts the story of how he assessed his former firm’s profitability, only to discover that “our largest customer was among our least profitable.” Turns out, the firm had been focusing primarily on revenues, not the statistics that mattered.
Mauboussin goes on to say that “this mistake permeates businesses—probably even yours—driving poor decisions and undermining performance.” His words should be a wake-up call to the value of using gross profit margin to your advantage.
What is Gross Profit Margin?
As Inc. magazine puts it, it’s “the ratio of profits earned to total sales receipts (or costs) over some defined period,” and “a measure of the amount of profit accruing to a firm from the sale of a product or service.” If that sounds a bit heady, don’t worry; we’ll break it down. But first, you need to know your gross profit.
How to Calculate Your Gross Profit
As you may already know, you can calculate your company’s gross profit by subtracting the cost of the goods you’ve sold from your total revenue. So if ABC, Inc. made $100,000 last year selling shoes and initially paid $70,000 for the shoes, their gross profit would be $30,000.
How to Calculate Gross Your Gross Margin
To then figure out the gross profit margin, all you need to do is divide the gross profit by the total revenue. In ABC, Inc.’s case, they would divide $30,000 by $100,000 for a gross profit margin of .30, or 30%. Here’s the gross profit margin formula spelled out:
(Revenue – Cost of Goods Sold) ÷ Revenue = Gross Profit Margin
Simple enough, right? But what implications do these numbers have in the long term?
How To Use Gross Margins to Ensure You’re Headed in the Right Direction
If our hypothetical ABC, Inc. discovers that the gross profit margin of men’s shoes is significantly lower than that of women’s shoes, they will probably want to look into why that is. To do so, they might break the categories down even more, into styles or brands.
If ABC were to discontinue those shoes with the lower gross margin, they might invest more in the shoes – men’s or women’s – that are clear sellers. Or they may consider replacing the discontinued shoes with a new style or brand that has the potential to shine.
You Must Track and Measure Your Gross Profit Margin
Since you don’t want to be among those businesses that focus on the wrong numbers, it’s time you pay attention to your gross margin.
As you should be able to see, your profit margin is easy to calculate, assuming all your other numbers are in order. And once you’ve figured it out and broken down the data, begin to keep records – yearly, monthly, maybe even weekly – depending on your habits of operation. Start doing this today, as it will serve as your roadmap as you traverse the unpredictable market highways.
Analyzing Data Will Help You Make Better Business Decisions
Once you’ve begun to accumulate sufficient data, you then need to analyze it – continuously.
Keep all your records organized using software designed for such purpose, and take note of any trends you observe. Is a particular product unexpectedly hot during certain times of the year? Does your best-selling product have a lower gross profit margin than your less popular sellers? Is your gross profit margin down from last year, despite an increase in sales? Any data can be telling, but it’s impossible to utilize the data if you don’t take the time to keep consistent records.
You’ve started keeping a record of your gross margin, and you’ve analyzed the data. Now what?
How to Improve Your Gross Profit Margin
Raise Your Prices
One thing you can do – and you’re not going to like this – is raise prices.
No one enjoys asking clients to pay more than they already do. But as your costs continue to increase, it’s unreasonable to expect your clientele to continue paying the same prices for what you have to offer.
Profit First author Mike Michalowicz feels strongly about this. “Your best customers will be surprised that you didn’t raise prices sooner because they value your work,” Michalowicz writes on American Express’s financial column “Open Forum.” “It’s possible that you may lose a customer or two over your increase, but those clients are likely to be your problem children anyway.”
Lower Your Costs
After analyzing your profit margin data, you may realize you sell a lot of a particular product that maintains a low-profit margin. You don’t necessarily want to cut that product, so what should you do?
One thing you can do is look for other ways to lower your costs. Start by looking into more affordable ways to obtain the product or cheaper versions of goods similar to your high sellers that might continue to generate steady customer interest.
Another thing to consider is taking a look at your vendor. How do their prices compare to those of other suppliers? Are there any ways to cut shipping or supply costs
In the online financial community, Money Crashers’ bestselling author Michael Lewis suggests negotiating with your vendor for a long-term plan. “Offer to use a supplier exclusively for a specific period in return for a set lower price and better terms,” he writes.
In the same piece, he suggests something many small business owners would probably never consider: combining orders with other small businesses that rely on the same supplier, even if it’s with the competition.
“Since you and your competitor will be paying the same price for the same material, neither will gain or lose an advantage over the other,” he states. “It is a win-win for each company.” And if all else fails, consider moving on to another vendor completely.
Remove Poorly Performing Products and Services
One of the best ways to increase your overall gross profit margin is by discontinuing products and services that underperform or have a lower profit margin.
We’re talking basic math here; but again, this highlights just how important it is that you keep records of your gross profit margin and break things down into as many product categories as possible. Otherwise, you may never know what those underselling products are.
That said, don’t be too quick to toss those low-performing products out the window. There will always be exceptions. In another Inc. article, Avondale Strategic Partners co-founders Karl Stark and Bill Stewart caution, “You always need to prove why maintaining an unprofitable product in the short term will create value over the long term.”
Some reasons you might justify keeping underselling products in stock – they suggest – include the possibility that they’re driving the value of other products, that they could initially attract clients, and they may help earn client trust by encouraging product or business acceptance. If you can’t ensure those goods are adding any benefit, say Stark and Stewart, “It’s best to stop the losses.”
Fire Poor-performing Clients
Depending on the industry you’re in, you may also have the dread-inducing option of cutting ties with a client. Most people cringe at the prospect of dismissing anyone they have a professional relationship with, but does it need to be so uncomfortable? Writing for Entrepreneur, Erika Napoletano doesn’t think so. “The overall health of your business, whether you’re a company of one or 1,000, is what matters most,” the author and branding strategist argues.
Stop Waste and Theft
Is any of your product walking out the door without being paid for? Not literally, of course. But most companies experience some form of product loss due to breakage, theft or poor inventory management, and likely all three.
While turnover is unfortunate, some loss is inevitable, and many small businesses fail to consider the devastating effects of turnover. Demand Media’s David Ingram has one suggestion for taking better control of your inventory: Keep less product in stock.
In addition to saving you storage space and costs, “Keeping less inventory on hand for shorter periods can also reduce the impacts of spoilage, waste, damage, and theft,” he says, all of which serves to give you more control of what you have and helps you increase your overall profit margin.
No matter how turnover affects your business, it’s worth touching on the value of making sure your inventory system is accurate. Bain & Company partners underscore the importance of maintaining a robust inventory system.
“The diagnosis of your inventory health sets your company up for significant opportunities to improve expense and asset effectiveness and creates potential for capturing missed top-line sales,” they say in the Wall Street Journal. “Often ignored, inventory pulse checks can be a huge lever to improve the financial health of a company.”
Data Remains the Basis for Increasing Your Gross Margin
Regardless of your plan of action, one thing bears repeating: You can break down your gross profit margin into as many categories as possible, but none of it amounts to success unless you continually examine your data and then act on it.
Taking full control of your business means looking for areas where you can cut losses or increase gains. And as technology continues to make data collection easier, Mauboussin reminds us, you have fewer excuses than ever. “Companies have access to a growing torrent of statistics that could improve their performance,” he says, “but executives still cling to old-fashioned and often flawed methods for choosing metrics.”
Don’t hold on to practices that are hurting your business. By targeting your gross profit margin using modern tools of the trade, you can keep your business moving forward on that long and winding road toward success.
You’ll not only have more control over the factors that matter and decrease your stress level, you’ll also have an advantage over your competition. Because if you can isolate the source of your financial woes and successes today, Mauboussin says, “identifying and exploiting them before rivals do will be the key to seizing advantage.”
Gross Profit and Gross Margin Calculator
Use the calculator below to figure out your gross profit and gross margin.
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Definitions and Formulas
Cost of goods sold: hard costs for goods. These goods are then sold to generate revenue and, hopefully, profits.
Revenue: total amount of money brought in from sales of products or services.
Gross profit: money left over after subtracting the cost-of-goods-sold from revenue (Revenue – Cost of Goods Sold).
Gross profit formula: Gross Profit = Revenue – Cost of Goods Sold
Gross profit margin: percentage companies use to understand how much money they make on products and services they sell. The higher the margin the better as this means the company is making more money for every dollar they spend.
Gross profit margin formula: Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
Net Profit: different from gross profit. Net profit subtracts operating expenses, including rent, transportation fees, hourly wages and such, from revenue.
Industry Gross Profit Data by Sector (2014)
How gross profit is used in sales: Investopedia
Calculating ideal profit margin: QuickBooks
Data provided by YCharts