We are going to step out on a very sturdy limb and guess that you are in business to make money.
You probably would also like to keep as much money as possible. There are many ways to do that, but one of the surest ways to ensure the financial health of your business is to increase your gross profit margin.
In this post, we will explore gross profit margin and how to maximize it to improve your overall business performance.
What is Gross Profit Margin?
Gross profit margin is simply the percentage of money you have left over after subtracting the Cost of Goods Sold (COGS) from your net sales.
Let’s say your company has $100,000 in net sales this month. Your COGS is $75,000, which leaves you with $25,000 in profit. Your gross profit margin for that month would be 25%.
Having that information is an important tool that you can use to measure the financial health of your company regularly. Comparing Gross Profit Margins over time also helps you spot trends in your business. For instance, if they tend to stay in the same range and then suddenly vary wildly one month it could indicate a problem.
You may have noticed we are using net sales rather than gross sales. That is because net sales give you a more accurate picture of your profitability. There are deductions such as discounts, returns, etc. that the larger “gross sales” number doesn’t show you. (We’ll get into that more in a minute when we talk about the formula for calculating gross profit margin.)
The Role of Cost of Goods Sold (COGS)
Before we do that, let’s look at the role of Cost of Goods Sold and its impact on gross profit margin.
Cost of Goods Sold (COGS) is the total of all costs related to items involved in manufacturing, producing, packaging, and delivering a product or service that you have sold. You are probably familiar with the saying “It takes money to make money.”…that’s referring to COGS.
Accurately calculating COGS can lead to better profit margins. After all, better information leads to better results which helps you make better decisions.
COGS is primarily related to inventory. The formula used to calculate COGS is: Beginning Inventory + Purchases – Ending Inventory = COGS. (Purely service-based businesses such as accountants, attorneys, consultants, etc. that do not deal with physical products use a “cost of services” figure instead of COGS.)
Because inventory plays such an important role in your COGS, you must use good inventory management practices to reduce COGS and maximize your gross profit margin. Business News Daily has these “10 Essential Tips for Effective Inventory Management” if you need help.
Profit Margin Calculation
There are various methods for calculating profit margin. Regardless of which you use, always remember that the goal is to have accurate financial data that allows you to make the best decisions.
The basic formula is: Gross Profit Margin = (Revenue – COGS) / Revenue
- Revenue is total sales minus any returns, discounts, or allowances.
- COGS is the total costs involved in producing and providing the product(s).
Analyzing Your Gross Profit: Gross Profit Analysis
- Introduce the concept of gross profit analysis and its importance.
- Discuss how businesses can use gross profit analysis to identify trends and areas for improvement.
- Highlight tools and software that can assist in gross profit analysis.
Simply knowing what your gross profit margin is isn’t enough. You need to be able to understand what it says about the health of your business.
Gross Profit Analysis is the process by which you determine why your gross profit margin (GPM) changes from one reporting period to the next. Then, armed with that knowledge, you can take steps to keep your GPM more in line with company expectations.
A higher gross profit margin means that you are keeping more revenue and are doing a good job of managing costs and generating profit. Similarly, a drop in GPM can indicate that there are serious problems you need to address.
Gross profit can change for any number of reasons. Some of the factors commonly affecting GPM include:
- Sales price changes
- Sales volume changes
- Purchase price of materials changes
- Amount of materials needed changes
- Labor hours or rates change
- Overhead costs (both fixed and variable) change
Read about this topic: “What is Gross Profit Analysis” from Accountingtools.com.
Strategies to Increase Gross Profit
Now that we have an understanding of what Gross Profit Margin is, its importance, and how to analyze it, what are some strategies to increase gross profit in your business?
Here are some actionable tips you can start implementing to boost your GPM:
1. Pricing Strategies
One of the quickest ways to increase GPM is to simply raise your prices. If your costs remain the same, but you suddenly take in more revenue for the same product, your GPM will go up.
However, this is a caution that goes with this tip: you can raise prices beyond what customers are willing to pay. When that happens, sales will go down and take your GPM with them. So be strategic and know your market and your customers well instead of blindly raising prices.
Similarly, when you lower prices (flash sale, discount, clearance, etc.) you can sometimes boost sales volume in such a way that it improves your GPM.
2. Cost Control Measures
Another factor affecting GPM that is within your control is lowering your costs. Look around your business and see if there are ways you can do things cheaper or more efficiently.
If you rent, talk to your landlord about improving your contract. (Especially if you’ve been with them for a while as a reliable tenant.)
Renegotiate (or cancel) other contracts that are expensive or outdated.
Shop around for other suppliers with better prices.
Make sure your employees are maximizing productivity while on the clock.
Read our post on “14 Creative Ways You Can Reduce Small Business Overhead Expenses” for even more ideas.
3. Revenue Optimization Techniques
Consider ways to “upsell” or create added value to your existing customers. Create a customer loyalty program or subscription model to encourage repeat business. Bundle products to raise revenue while letting customers get a good deal.
Boost Your GPM With Help From Our Pros!
Gross profit margin is essential in evaluating the health of your business. Put these ideas to work in your company and customize them for your unique situation to see your GPM begin to improve.
For one-on-one help streamlining your business to increase revenue and trim costs, schedule a call today with one of our experienced business pros. We’re much more than just an accounting firm…we’ve been in the trenches with small business owners just like you for over 40 years, and we’d love to share what we’ve learned to help you succeed.
