Gross Profit Optimization
Aug 16, 2008
One vital aspect that companies often overlook in starting or managing a business is that of optimizing gross profit. Gross profit (total sales revenue minus direct costs) is what is left over after costs associated directly with the sale of a product or service, such as materials and direct labor, are paid for. This is an extremely important number for every business to manage, as it impacts both the likelihood of reaching breakeven and the amount of profit that is earned beyond breakeven. In other words, it directly impacts risk and return.
To optimize gross profit, it is necessary to calculate and understand gross profit percentage, commonly referred to as gross profit margin. Gross profit margin is a company's total sales revenue minus its direct costs, divided by the total sales revenue, expressed as a percentage. Gross profit margin represents the percent of total sales revenue that the company retains after incurring direct costs. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligation.
Total Sales Revenue - Direct Costs
Gross Profit Margin (%) = Total Sales Revenue
This number represents the proportion of each dollar of revenue that the company retains as gross profit. For example, if a company's gross profit margin is 50%, it would retain $0.50 from each dollar of revenue generated, to pay for selling, general and administrative expenses, interest expenses and distributions to owners. The levels of gross profit margin can vary drastically from one industry to another depending on the business. For example, software companies will generally have a much higher gross profit margin than manufacturing companies.
To illustrate how gross profit margin affects breakeven and profit, consider a company with $300,000 in fixed overhead expenses. If the firm's gross profit margin is 50%, it would need to generate sales of $600,000 to cover its overhead. If that same company were able to achieve a gross profit margin of 52% instead, breakeven would decrease by $23,000 or approximately 4%. The company would then begin earning a profit of $0.52 on each dollar in sales after revenues reach $577,000, rather than $0.50 on the dollar after $600,000.
Optimizing a company's gross profit helps a company avoid problems with prices that are too low and direct costs that are too high, and therefore problems with breakeven and profit. When a company is generating adequate sales but gross profit margins are low, it signals an issue in one or both of these areas. This lack of understanding often leads to decisions that only worsen the company's position, such as attempting to increase sales via lower prices, leading to even smaller gross profit margins.
Gross profit optimization often does not get the attention it deserves. Companies should be aware of the factors that will impact gross profit margins and pay close attention to them. B2B CFO advisors can help companies find a benchmark for gross profit margin using competitor data and industry averages to provide a targeted goal. In addition, it is important to be aware that the factors impacting gross profit margins may change over time. For instance, costs may increase due to inflationary factors that may necessitate a compensating annual price increase. B2B CFO advisors work with companies to track gross profit margin over time to ensure that it does not slowly deteriorate and lead to cash flow problems.