We’ve talked about what drives your business. Have you figured it out yet? Another aspect to consider is having a good understanding of how your business is doing. Sure someone in your company might tell you sales are up or down or we have enough cash in the bank to cover payroll. At the end of the day, do you really have a good understanding as to how your business is performing?
Today we’re going to zero in on profit and loss ratios in addition to an important operating ratio – the gross margin. If you don’t know these off the tip of your tongue then you need to do some home work.
How much money is left after subtracting your product costs? Are you including all of the costs related directly to those sales? They might include raw materials, labor, marketing and shipping expenses otherwise known as cost of goods sold.
Gross Profit = Sales – Cost of Goods Sold
Net Operating Profit
This represents how much money is left over before after all expenses, including overhead, employee salaries, manufacturing costs, and advertising costs have been deducted from gross profit.
Net Operating Profit = Gross Profit – SG & A *
*(Selling, general and administrative expenses)
How much money is left over after all costs and expenses are paid. What’s different between net operating profit and net income is the inclusion of other expenses like interest, depreciation and taxes. Sometime referred to as the “bottom line” and is an extremely important measure of how profitable the company is over a period of time.
Net Profit = Net Operating Profit – Interest, Other Expenses – Taxes
Gross Margin – Keep Your Eye Out for Eroding Margins
This measures the percentage of every dollar of sales which becomes gross profit.
Gross Margin = Gross Profit/Sales
What many business owners fail to realize is the impact of how much a slight change in the gross margin can impact profits. Let’s say a company is doing $1 million in sales and has a 40% gross margin or $400,000 in gross profit. Operating expenses are $300K for an operating profit of $100K. By better buying of materials or improved efficiencies, the business can improve the gross margin from 40% to 45% or a 12.5% improvement. The impact is huge because operating profit will increase from $100K to $150K, an amazing 50% improvement.
On the flip side, a declining gross margin can have a disastrous impact on profitability. How many times have you heard someone say we’ll make it up on volume or the sales person says I can land this new account if we agree to their price concessions?
Companies are scrambling for sales these days and trying to generate sales with a price reduction is a slippery slope. So the question is, using this same example, how much would sales need to grow to generate the same gross profit if the gross margin slips to 35%. In order to generate the same gross profit the company would need to generate $1,142 million in sales ($400K/35% = $1,142K or $1,142K X 35% = $400K). So again, watching the gross margin is extremely important and at all costs, try to avoid buying business through price concessions.
Next time we’ll focus in dissecting the balance sheet – stay tuned.