In this month’s column we explain the importance of Gross Profit (GP). This is a very important number and metric that every business owner should track on an ongoing basis in their business.
Lets start by explaining what gross profit is – it is the profit made after deducting the direct costs of producing or buying the goods or services being sold. It is found in the income statement and the formula to arrive at it is Sales – Cost of Sales = Gross Profit.
Gross profit is very important for 2 reasons:
- It is the first level of profit (if this is too low, you’re going to have a problem)
- It is what’s left to run the business on i.e: the gross profit has to be sufficient to cover all your overheads and have enough left over for profit.
Example – lets say your business sales for the month were R 1,000,000 and your cost of sales is R 600,000. That means your gross profit is R 400,000 (and 40%). That R 400,000 has to be sufficient to cover your business overheads for the month and leave enough for profit. In this example it means for every R 1 of sales, you make 40 cents gross profit.
If your GP % (Gross Profit / Sales) varies from month to month, you need to analyze it to find out why. Reasons for GP % fluctuations vary but here are the main ones:
- Your suppliers increased their prices and you didn’t pass this on to your customers;
- You ran some promotions / specials or gave discounts in the month;
- Your sales mix changed i.e. the proportion of lower margin products to higher margins products sold in the month changed;
- You have theft or wastage happening in your business.
Don’t just accept a fluctuation in GP % without getting to the bottom of why!
Lets assume your average GP% is 33% and your want to increase this to 35%, you have 3 levers to pull in this regard:
- Increase your selling prices;
- Negotiate better pricing with your suppliers / reduce input costs;
- Sell a higher proportion of higher margin goods and services in relation to lower margin goods and services.
Our Offer to You
At MJ Chartered Accountants, we have the expertise to analyze and guide you on the management of your gross profit. Reach out to us by emailing firstname.lastname@example.org and schedule a complimentary session with us to discuss your GP and how to improve it.