For majority of business owners, the primary aim is to increase the revenue and to boost the sales potential of their business over time. There is no doubt that increase in top line(revenue) of your business’s profit and loss account is important for growth of your business, however, revenue dollars solely do not provide enough information to help you measure the success and growth potential of your small business.
This article will highlight one of the most important profitability ratios to help your small business succeed. In this blog, we will do the in-depth analysis of:
- What is a Gross Profit Margin?
- Why this ratio is important?
- What could be the main reasons of your business’s declining gross profitability? and
- What are some measures you can apply to overcome this declining trend?
What is a Gross Profit Margin?
Gross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of goods sold. Simply, the ratio measures how effectively a business utilizes its direct materials and direct labour to produce and sell products profitably.
Mathematically, the Gross Profit Margin is calculated by subtracting the cost of goods sold from net sales and dividing the difference by net sales.
GROSS PROFIT MARGIN = Net Sales less Cost of Goods Sold
The ratio can also be calculated in a percentage by multiplying the Gross Profit Margin by 100.
GROSS PROFIT MARGIN (%) = Net Sales less Cost of Goods Sold x100
Why is Gross Profit Margin is an important ratio?
The ratio is extremely useful and should always be measured when analysing your set of financial statements. Glancing over your Sales and/or Gross Profit can be deceiving as the trends may not display the real picture of what is going on in your business. Let us look at an example:
Below are the Sales, Direct Costs and Gross Profit numbers presented from a sample company:
At first, the table above shows some promising signs on the growth of the business, as it confirms the following:
- The sales are increasing year on year between 2018 to 2020.
- Even though the Gross Profit decreased by $1,200 from 2018 to 2019, the overall metric from 2018 to 2020 shows an increase of $3,676.
However, these trends do not show the true image of how profitable this business is. In fact, it is the Gross Profit Margin which will help you to find any negative profitability. Let us dig into Gross Profit Margin from above numbers:
Gross Profit %
Looking at this trend helps us to acknowledge that there is a profitability issue in the business as the margin is continuously declining from 2018 to 2020.
This is the stage where you need to focus on the drivers of the Gross Profit Margin.
The truth is that a declining gross profit margin can ultimately impact on future business profitability and can also create cash flow problems for the business.
Why is your Gross Profit Margin declining and how can we correct?
As outlined above, reducing gross profit margin is a matter of concern for your small business profitability and cash flow.
To correct the declining trend of the Gross Profit Margin, first we need to figure out what are the factors reducing this ratio?
Let us look at 5 major questions you should ask yourself when you see this trend, and what are some measures you can apply to overcome this negative trand :
1. Has your Direct Costs increased disproportionately to Sales?
One of the key reasons of your declining gross margin is unproportionate increase in direct costs of your business. A direct cost is a cost that varies directly with the production of your goods and services. Examples of direct costs are direct labour and direct materials.
In simpler words, the gross margins of your business will fall if the price of the direct costs are increasing in greater proportion to increase in the sales prices of finished goods and services.
If this is the case, some measures listed below may overcome this issue:
- Negotiating with your current suppliers for better deals.
- Considering switching suppliers for preferable rates.
- Direct labour costs review for possible unnecessary cost reductions.
2. How profitable is your product mix?
Product mix is basically how the business’s product base is made up.
Declining margins may be an indicator of inappropriate product mix in your business. For example, a possibility of higher concentration of a product in your product mix which has high sales but has lower profitability.
In this case, as a business owner may need to focus on encouraging sales for products which has higher profitability margins or even perform analysis on whether you need to discontinue the products which offers lower profitability but demands considerable efforts.
3. Is your pricing structure correct?
One of the main reasons of falling margins is low prices.
Unfortunately, majority of small business owners feel that they will lose customers and loss share of their revenue if they raise prices. However, this decision offset any potential profit they could earn.
In fact, the main reasons why small business does not increase price is lack of understanding of appropriate pricing strategies.
Here are some strategies you can build in your business:
- Review of your pricing regularly and ensure to update with rising costs.
- Adding value to your business’s products and services your Business and do not compete on prices to match competition.
- Analyse or hire a consultant to understand impact on annual financial statements of any possible discounting strategies in progress.
4. Does your business have appropriate customer mix?
Like your product mix, customer mix is purely how the business’s customer base is made up.
The customer mix with higher percentage of lower profitable customer will affect your overall gross margin. To illustrate, discounting your products to attract customers who are price sensitive, can have severe impact on your profitability.
If this is a case, then, as a business owner you may need to analyse the profit margins on your customers and re-focus on marketing and promoting your products and services to customers who offer higher profitability margins to your business. In this scenario as well, a business consultant can help you to review your financial statements periodically to find the customers with high/low profitability margins and can assist with appropriate strategies to sell your goods and services to the target market.
5. Does your business have efficient processes implemented?
Efficiency in current operational systems and processes is key to profitability of any business. If the business processes and systems are outdated or even in need of updating, this will result into inefficiencies and will decline in gross profit margins. These deficiencies in systems and processes are not visible through any reviews of the financial statements of your business, these can only be captured through a thorough review of the pain points in your current processes and systems.
Few examples which we have seen multiple times with our clients are constant duplication of efforts, requirements to complete unnecessary forms and applications, performing services to customer which adds no value and lack of inventory planning resulting in required raw materials not available to complete work etc. This process analysis is equally important to any financial metric in your financial statement and would need your regular reviews to correct any inconsistencies which can lead to deterioration of the business profitability.
To summarize, below questions need addressing for declining Gross Profit Margins in your business:
- Has your Direct Costs increased disproportionately to Sales?
- How profitable is your product mix?
- Is your pricing structure correct?
- Does your business have appropriate customer mix?
- Does your business have efficient processes implemented?