All successful business owners and financial managers want to stay on top of profit, as it is essential to the firms long term success and growth. We all know the basics of profit – i.e. it’s what left after expenses are paid and ultimately it’s a measure of how successful we are in operating our company efficiently. Over time a company that has less and less profit will be unable to pay bills and buy materials. Also both lenders and investors will of course view the business as problematic, leading to an outflow of capital. And of course those profits allow us to grow our businesses to even new heights of success.
Let’s take a look at some basic ways that business can measure profits, from the view point of are they enough, and how can we improve and control them.
A great way to start is for a business owner to understand and be able to address ‘gross margins ‘. It is simply the gross profit deiced by net sales, and we then multiply by 100 to express the number as a percentage. What does this number tell us? It allows us to see the difference between our sales and the cost of those sales. (Keep in mind that doesn’t reflect our administrative expenses also) A higher gross margin is good, as it allows bills to be paid and leave a reasonable profit for the owner. Business owners from small start ups to major corporations watch the gross margin very carefully.
How does the business owner address and interpret gross margin – Essentially it reveals that material costs are too high or sales are too low. Steps must be taken to fix both or either!
We need to note that that gross margins are different in every industry. In the grocery business margins are very low, but sales and turnover are very high. Products are essentially a commodity in the grocery industry. Don’t forget also, using our grocery business as an example, that there are a large number of products in that store. Each product delivers a different gross margin to the business owner, some more, some less. Therefore we can glean from this that we must watch the mix of products and the margin they deliver back to our company.
Another takeaway from our gross margin analysis is that overall risk to the business increases when we are in a low margin business – there is simply little room to move when things go wrong! Business owners have the option, and many do, of maintaining their margins by a pricing strategy – let’s say a business owner has a budget goal of achieving a 25% gross margin. As his material costs and inventory costs change he simply re prices his product to achieve that desired margin.
In summary when managers understand their gross margin they can more effectively buy goods and price them correctly. That’s important.
Stan Prokop is the founder of 7 Park Avenue Financial.
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