Small Businesses Need to Keep a Close Eye on Gross Profit

GROSS PROFIT AND GROSS PROFIT MARGIN ARE KEY INDICATORS FOR BOATYARDS AND OTHER SMALL BUSINESSES...

Few small business owners and managers have the time and luxury of performing complete financial analysis of their company's performance each week or even each month. Therefore, they will often choose a single metric by which to judge how their business is performing.

The performance metric chosen depends on from  where in the ranks an owner or manager rose, and on what his or her primary business orientation is...

If the exec or manager hails from sales, or is presently still engaged in sales, the most likely metric chosen will be Gross Revenue. If he or she comes from the accounting side of business, the most likely metric chosen will be Net Profit. However, in my experience, neither of these is a truly useful operational, on-the-fly metric for keeping a running eye on the health of a small business.

A long-time client of mine, a prominent and very successful businessman, once told me that the marching order he gave his sales force was, "Promise them anything, but get the order!"

To him, fulfillment was an entirely separate issue from sales, and a problem to be dealt with on down the road. What was really important was to grow sales, which in most cases makes up the bulk, if not the entirety of gross revenues.

But, small businesses often fail to see increases in profit commensurate with increases in sales, because they fail to achieve the vaunted, but highly elusive economies of scale available to big business.

Indeed, sometimes increases in sales actually result in decreases in profit, because the increased volume either overwhelms the company's infrastructure, or requires additional quantum investment in capital equipment, which then goes underutilized.

Consequently, on the one hand, gross revenue and gross sales (often, but not always the same thing) are poor working metrics for small businesses. But on the other hand, net profit isn't much better as an on-the-fly tool, because it is affected by too many variables, some of which are hard to predict and project at any given point in time.

In many cases, the best working metric in a small business environment is gross profit, and/or its handmaiden gross profit margin.

Gross profit can be defined as gross sales less the direct cost of materials (or COGS) and direct labor. (Direct labor cost should include gross wages paid plus what can be termed "payroll overheads", i.e., F.I.C.A., F.U.T.A., and the like.)

The idea here is to ask, "What are we making on the goods and/or services we're selling and delivering, after deduction of our direct costs?" Because direct costs are more easily and clearly defined and projected, gross profit and gross profit margin are more quickly and conveniently determined on-the-fly.

The importance of gross profit and gross profit margin should never be overlooked or minimized...

For example, if you are considering chasing increased gross sales volume, unless you see or project an increase in gross profit, with a concomitant maintenance of gross profit margin, you should really think more than twice about your move.

The value of achieving a prospective increase in gross sales, is highly dubious, if you cannot see a clear increase in gross profit. And if you have to choose between increasing gross sales and increasing gross profit margin, you will often find it preferable to choose the latter. For depending on the business sector in which you operate, every point increase in gross profit margin may be worth as much as two or more points increase in gross sales. — Phil Friedman

Author's Notes:  If you found this article of value, you may want to take a look at some of my other writing about small business operations and management:

"Selling Bull Chips in a Bag"

"Tips for Successful Consulting"

"Maximizing Throughput on Fixed Assets and Overheads"

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About me, Phil Friedman:  With 30 some years background in the marine industry, I've worn numerous hats — as a yacht designer, boat builder, marine operations and business manager, marine industry consultant, marine marketing and communications specialist, yachting magazine writer and editor, yacht surveyor, and marine industry educator. I am also trained and experienced in interest-based negotiation and mediation. In a previous life, I taught logic and philosophy at university.

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Text Copyright © 2016 by Phil Friedman — All Rights Reserved
Images Credits:  Phil Friedman, FreeDigitalPhotos.net, and Stuart Miles