A lot of factors affect profitability, but let’s focus on the gross profit that’s left after subtracting your costs of selling products or delivering services from your sales revenue. The largest percentage of your costs is tied up in these costs of goods sold. Because of this, even small changes in margin can have huge impacts.
Today’s economy has resulted in some brutal price wars that make it difficult, if not impossible, for many companies to raise prices. Revenues have decreased dramatically in many cases. As a result, profits have taken a hit and some owners who were expecting to transition out of their businesses over the next several years have had to delay their exit plans.
Many of us have done as much cost cutting as possible. (Does the phrase “to the bone” ring a bell?) But based on the evidence we’re seeing from around the country in many different types of industries, we believe that opportunities to build profits remain. And profits are more important than ever for your company’s day-to-day survival, long-term health, and for laying the foundation for a successful ownership transition.
While there are a lot of factors that affect profitability, we’re going to focus on gross profit – that is, what’s left after you subtract from your sales the costs of selling your product (called cost of goods sold) or delivering your service (cost of sales). While it is critical to keep an eye on all costs, in almost every business model the largest percentage of costs are tied up the company’s costs of goods sold. Because of this, even small changes in margin can have huge impacts.
Let’s say your sales are $1 million and your gross profit is $340,000. Stated as a percentage, you have a gross margin of 34 percent, which means that after you’ve paid for the goods that you sold, 34 cents out of every dollar you make in sales is “left over” to cover all of your other operating expenses. However, your industry peers’ gross margin is 35 percent. That one percent difference might not seem like a lot, until you realize that if you had achieved that same 35 percent margin in your company, your gross profit would have been $350,000. That’s $10,000 more that could have gone straight to your bottom line, assuming none of your other operating costs change.
Here’s my top ten list for increasing profit and company value when there’s downward pressure on prices.
1. SET A GROSS PROFIT GOAL – MEASURE IT PROPERLY – WATCH IT LIKE CRAZY
Start by ensuring that your accounting system is categorizing the right costs in this area. You’ll need the ability to compare your company to others in your industry and to do so you’ve got to compare apples to apples. Be sure your cost-of-goods categories match those of your industry peers.
Industry benchmark studies, sometimes available from your trade association or The Risk Management Associates (RMA), can provide comparative data so you can learn what type of gross margins the profit leaders in your industry achieve and set appropriate gross margin goals. Get profit and loss statements with columns that show your numbers in both dollars and percentages. That way you can see changes in gross profit in absolute terms, not just changes due to sales increases or decreases. You should track your gross margin on at least a monthly, if not weekly, basis so you can take quick action.
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