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Gross Profit Optimization
IMPROVE YOUR PROFITABILITY
Gross Profit (or gross margin) is a very important financial measure in almost every type of company. It is the profit from sales before administrative, sales and marketing expense, interest and other expense.
It is important to focus on Direct Margin as a component of Gross Profit:
- Direct margin equals sales less direct costs. For a manufactured product direct cost normally includes direct labor, raw materials and subcontracted costs. For distributors or retail this is the cost of purchasing the product for resale. For service firms this is a bit trickier, but normally would include direct labor, materials, subcontractors, supplies and other variable costs that are directly attributable to the completion of the service.
- Gross Profit is direct margin less the cost of the operational overhead required to manufacture the product, provide the service or distribute the product. The key word is operational overhead. It is very important to separate operational costs from administrative expenses, sales and marketing expenses and other expenses.
Gross Profit Optimization therefore is the process of optimizing, or maximizing the profits from producing the product or service. Here are the steps:
- Identify the direct costs. Set up separate ledger codes so you can track them. For example, most firms do not properly track labor...they put it all in one bucket. Direct labor should only include time spent producing the product or service; all other labor should be coded to indirect labor, including breaks, vacations, holidays, PTO, seminars, training, meetings, etc. Indirect labor is overhead and should be coded as such.
- Calculate the direct cost of each major input as a % of sales.
- Develop detailed strategies as to how to lower each of the direct costs. Assign teams, responsibilities and timelines for achieving specific cost reduction goals. Often the goals will be a percentage of that direct cost to sales. If direct labor has been running 20% and materials 30% of sales, develop specific action plans to bring labor down to 18% and materials to 28%. This will bring 4% directly to the bottom line. Detailed labor analysis and carefully planned purchasing strategies are required to achieve these results.
- Identify direct margins down to the product line and item level. Fix or rid the items that do not add value to the company.
- Continue to track the cost/sales % over time to monitor your results and make sure you hit your direct margin targets.
- Analyze the overhead costs (including the indirect labor) and set additional cost reduction goals for these expenses. Tackle the big ones first. Compare your costs with industry averages to benchmark your operations to your peers.
- Calculate the gross margin % of sales and track over time. If you improve your direct margins and reduce your overhead, gross profit will improve.
By breaking down your margins and developing specific strategies for each category of cost, you may be able to add substantially to your bottom line!
Please contact me if you are interested in learning how to apply Gross Profit Optimization techniques to improve your company's bottom line!