Gross Profit Margin: The Secret Financial Indicator Most Business Owners Ignore
Content was originally published on Inc.com on March 24, 2016.
It just may be the most undervalued, least understood, and most underutilized financial indicator your company has. It is a magic number that gives you an insider’s view at your profitability, pricing relative to production costs, and production efficiency relative to the marketplace.
What financial indicator am I talking about? Why it’s your “Gross Profit Margin” of course.
Let’s start off with a story to show you the power of your Gross Profit Margin.
Linda and Steve (not their real names) owned a ran a multi-clinic medical practice. At one of their clinics they had put in a “medical spa” to wow their patients. And it worked – seemingly. Patients came and loved the tranquility area where there were chilled juices and healing teas to sip before their massages and aesthetician and other beauty and anti-aging treatments.
Yes the medical spa was a challenge to staff and run. It required its own check in area, and ate into the expensive office space from which they operated that clinic location.
But Linda and Steve kept saying, “Hey, this spa is bringing in just shy of $500.000 per year of add on revenue, and relative to our $3 million per year surgical practice, that is great.”
On our second business coaching session (disclosure: Linda and Steve are now business coaching clients of my company, Maui Mastermind) I reviewed their financials and asked them a pointed question, “Were you aware that your medical spa is directly costing you $75,000 a year to run?”
“What do you mean?” they asked.
I pointed to where if they ran their financials by “class” (a feature of QuickBooks, the accounting software they used) and looked at their Gross Profit, their medical spa may have generated close to $500,000 of revenue, but it had a proportional “Cost of Goods Sold” (the direct costs to run and operate that area of the business) $75,000 OVER the revenue.
In other words, after you factored in the costs of those chilled juices, staff to operate it, and the product cost of the beauty products they sold to there, they lost $75,000 per year.
This was actually much worse as they hadn’t accounted for a proportional cost of the space it took to operate the medical spa in their Cost of Goods Sold, nor several other costs that really should have been proportionally attributed to this side of their business.
At a quick glance I estimated they were paying $150,000 for the enjoyment of running and operating that medical spa.
Now before you think you’re different, I want to caution you. My companies and I have coached several thousand business owners over 20 years and it’s been my direct experience that 9 out of 10 of business owners simply don’t understand their own business financials. And the one element they consistently ignore or misuse is their Gross Profit Margin.
First, let’s clearly define what you Gross Profit Margin is.
Formula: Gross Profit = “Total Sales” less “Cost of Goods Sold”
Your “Cost of Goods Sold” is your direct cost to produce or acquire to resell your product or service. It generally includes materials cost and direct labor costs.
When you express your Gross Profit as a percentage of your total revenue, then you get your “Gross Profit Margin”.
For example, if you were a business with $1 million in sales (total revenue) and a Cost of Goods Sold of $250,000, then your gross profit margin would be 75% ($750,000 gross profit divided by $1 million in total revenue.)
In a very important way, your Gross Profit Margin is a simple measure of your ability to be profitable. If it is too low, what that is saying is that your price relative to the cost of producing your product or service is simply too low for you to ever be profitable.
Remember, your Gross Profit only accounts for direct costs of producing your product or service, and not for any of the other costs of operating your business like sales, marketing, operations, admin, finance, let alone PROFIT for the owners.
The three things it really gives you a great clue to see are:
- Your pricing. A low gross profit often indicates a company that needs to raise its pricing and fast.
- Your production expenses. A low Gross Profit Margin often indicates that you need to radically reduce Cost of Goods Sold (especially if you operate in a niche where you will have a tough time raising pricing. If you can’t lower Cost of Goods Sold and you can’t raise pricing, then you may need to shift out of that business niche altogether. Yes this is scary and intimidating to even think about, but at least it would give you a shot at being profitable. And this kind of insight is exactly what your Gross Profit Margin gives you.More commonly your Gross Profit Margin will alert you to product lines you need to drop, or market segments you need to ignore. That’s what it did for Linda and Steve, it made it obvious that they needed to close their medical spa and instead reinvest the saved time, attention, and money into the more profitable parts of their practice.
- Your place relative to industry benchmarks. If you’re operating at a 60% Gross Profit Margin, and your industry averages 50%, that tells you something. If you operate at 50% in an industry that averages 60% that tells you something different.
The bottom line is that when you understand your Gross Profit Margin you gain a simple leading indicator to help you keep an eye on profitability, production costs, pricing, and cash flow.
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