Recently, several of our clients have been going through the process of either buying another business or selling their company. During the requisite work related to these actions there have been many discussions regarding how to analyze the profitability a company.
The profitability of a business is almost the sole determinant of whether it will succeed, making it the most important part of your business’ Financial area. Indeed, it is so important that the abundant profitability of a business can cure a number of “evils” throughout it. If you have a wildly profitable business, you can make a ton of mistakes in various areas of your business and still be successful because you have a large cushion for error.
When most people consider an organization’s profitability they think of the Net Income/Loss of the company. However, you should also consider another key tool you can use to measure and gain insight into a business, it’s Gross Profit. The significance of Gross Profit is that it is a “core” financial measurement, whereas Net Income/Loss has many factors that effect it and perhaps distort its value as an indicator of a company’s operations.
Gross Profit Analysis
The formula for calculating an organization’s Gross Profit is:
Revenue – Cost of Sales = Gross Profit
In the above equation, your company’s Cost of Sales (sometimes called Cost of Goods Sold) are those expenses of your business that are directly related to the production of your Revenue as compared to overhead expenses. For example, if you were a home builder you would produce your revenue by building and selling houses and the costs that would go directly into producing a house (your product) would be:
- The wages and salaries you pay your employees to build the house
- Materials (lumber, drywall…) that would go directly into the house
- Sub-contractor payments for areas that your business will not complete itself (e.g., plumbing, heating and air conditioning)
- Supplies (you buy 500 lbs. of nails that you use on four different houses)
- Rental of a bulldozer to clear the land and scaffolding to erect the house
All the above costs would be considered Cost of Sales because when you sell the house, these are the costs that were necessary to produce your product (a house). Once you subtract the direct expenses (your Cost of Sales) from the Revenue that you received from the sale of the house, you have the Gross Profit. What is the benefit of knowing your Gross Profit?
How Efficient is Your Business?
Your Gross Profit (also known as Gross Margin) shows how efficient your business is at producing its Revenue. This information is instrumental in enabling you to analyze your cost of sales and thereby increase your profitability. Gross Profit analysis looks at the Cost of Sales of your business and compares that to your gross revenue in dollar terms and on a percentage basis. Additionally, you can compare your Gross Profit percentage to your competitor’s or industry averages to provide information to improve your profitability.
There are two main benefits of having a higher Gross Profit percentage. First, it means that your business is more “profitable” (i.e., more efficient) in its revenue generation than your competitors. This is key because if you have two similar companies in the same industry and one’s Gross Profit Percentage is 75% versus the other one’s 50%, that means the first organization is 50% more efficient in producing its Gross Profit than the second one.
Relatedly, you can gain even more insights by comparing both your overall Gross Profit and at a component level – Cost of Sales (Labor, Materials, Supplies, Contracted Services, etc.) on a percentage basis to industry averages. Knowing this information is the first step to improving a company’s operations.
Greater Gross Profit Yields More Flexibility
Second, your greater Gross Profit percentage provides you with more flexibility with regards to how you choose to operate your business. This potential flexibility affects every area of your company by providing you the freedom to make decisions and to choose options that otherwise you could not select because of having constrained finances.
A good analogy to use for this “flexibility” is to imagine you were looking at purchasing one of two different sponges; one which absorbed 1 cup of water and one which absorbed 2 cups of water. If each sponge was about the same price, you would purchase the second one, because its ability to absorb twice as much water as the first one.
Ability to Absorb Overhead Expenses
Think of a business’ Gross Profit as its ability to absorb overhead expenses. If you have a higher Gross Profit percentage than your competitors and your industry provides healthy Gross Profits, your business has a greater ability to absorb overhead expenses (i.e., spend money) than do your competitors.
This greater ability to absorb overhead expenses can provide you with many options, for instance you could:
- Invest more in your Marketing and Sales area to generate additional revenue
- Expand your business
- Pay your employees more or provide more fringe benefits to them to increase their satisfaction and morale
- Pay yourself more or increase your fringe benefits
- Pay off business debts
- Distribute more money to the owners of your business
With enough Gross Profit, you can do almost anything!
“This Does Not Apply to Me”
Some business owners may be thinking “this does not apply to me” because we are a consulting, health care, internet marketing, etc. company and not a manufacturing, retail, or distribution business. The Gross Profit Analysis tool applies to all companies because unless you can magically produce your product (I am using the term “product” in the loosest sense of the term) your organization will incur some costs to produce its product. By properly calculating your Cost of Sales and Gross Profit you will obtain great insights into the efficiency and true Profitability of your business.
The mechanics of doing the above are quite straightforward; the only problem is that many businesses do not include costs that are truly Cost of Sales in the Cost of Sales section of their Income Statement, but instead treat these expenses as overhead expenses. The result of doing this is that the true operational efficiency of the business is distorted because its production costs are not being reflected in the most insightful manner.
Performing a Correct Gross Profit Analysis
To have accurate financial statements with which to perform a correct Gross Profit analysis, go through your Chart of Accounts overhead expense section and reclassify any accounts that should be Cost of Sales accounts. Then re-produce your Income Statement and re-do your Gross Profit Analysis.
In summary, by using Gross Profit as an analysis tool you will gain insights how you can minimize your Cost of Sales, which thereby maximizes your Gross Profit. When this is coupled with keeping your overhead costs under control you will improve the profitability of your business, provide more flexibility and reduce your need for financing.
If you need assistance in using Gross Profit Analysis in your company to maximize your profitability please contact us using the below information so we can show you how to use this tool to take your business where you want it to go.
Fountainhead Consulting Group, Inc. is an Innovation and Business Planning firm. During the past 17 years we have shown over 1,200 companies how to achieve their goals by using our unique, comprehensive and systematic, innovation, business planning and growth Structure of Success™, Innovation Academy™ and FastTrak Innovation Program™ methodologies. Using the components in these methodologies, each month we examine an aspect of how to transform your business or organization into a true 21st Century operation.
Office phone: (770) 642-4220
www.FountainheadConsultingGroup.com
George.Horrigan@FountainheadConsultingGroup.com
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