Once you have improved your business gross profit at a macro level, it is time to look at the mix of products you offer and the gross profit of each. Bettering your gross profit at the product level requires you to look not only at the GP of each product, but also the volume of sales per product.

Consider the following business scenario:

If you looked only at the column listing the GP% per product you might conclude that Widget B is the highest contributor to gross profit, followed by widgets D, A and C. However, when you take into consideration the volume of sales and how that impacts on the WGP% we learn that:

• Widget B contributes the least to the business gross profit; although it has the highest percentage GP, it is the least sold product
• Widget C contributes the most to the business gross profit despite having the smallest GP% because it has the highest sales volume

So, how do you use this information to better your gross profit?

To have the greatest impact on GP through an increase in prices, increase the price of Widget C by only a small percentage to return a large GP increase. For example, if you increase the individual GP of Widget C by 3% to 28% the overall business GP% increases to 35%. However, if you increase the individual GP of Widget B by 3% to 68% the overall business GP% increases to only 33.7%.

The WGP% data can also provide guidance over where to assign your resources. If looking at product GP% only you might consider it more important to have team members assigned to manufacture Widget B, at the expense of resources for the other products. However, given that the business earns more GP from Widget C, ensuring the resources are assigned to meet the demand on the product creating the most GP would be a better management decision.

If a decision must be taken to drop a product from the product line i.e. because of a lack of resources, production lines or similar, ensure the WGP% is used to identify the lowest performing product, rather than relying of GP% in isolation of sales volume.

Want more?
Download the Systems Mentors Gross Profit Analysis workbook (Microsoft Excel 2007) and work through the GP exercises with your business data. Good luck!

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When faced with poor financial performance many business owners try to increase their turnover to solve their bottom line problems. However, it is a misconception to consider turnover to be a measure of the business income. The real income of a business is the gross profit.

Before calculating profit values and taking steps to improve your business profitability, first let us baseline the terms used and what they mean.

Direct and Indirect Expenses

Understanding direct and indirect expenses is the key to recognising the difference between gross profit and operating profit:

• Direct expenses are those incurred as part of the process of earning the revenue. These expenses are directly proportional to sales. For example, the cost of materials is a direct expense. If a widget costs $2 each and you sell 1 widget the direct expense for the material is $2; if you sell 5 widgets the direct expense for the material is $10. Direct expenses include:
  • The cost of materials that are sold, or are used to make a product that is sold
  • The cost of labour to manufacture the product or deliver a service
• Indirect expenses are those that your business incurs irrespective of whether you sell 1 widget or 5. Indirect expenses include:
  • The cost of owning or leasing premises for your business
  • The cost of services and utilities
  • The cost of labour that is employed in your business but is not used to directly earn revenue from sales, for example office and accounts personnel, management

Gross Profit

Gross profit is the revenue from sales less the cost of goods or services sold. Gross profit is calculated as follows:

Gross profit is sometimes also called gross profit margin or simply margin. Gross profit may also be presented as a percentage value. Gross profit percentage is calculated by dividing the gross profit $ by the revenue from sales $. In the example above the gross profit percentage is 54%.

Operating Profit

Operating profit is the balance remaining of revenue from sales less the direct and indirect expenses. Put another way, operating profit is the gross profit less the indirect expenses. Operating profit is calculated as follows:

Operating profit is often referred to a net profit because it is net of all expenses, both direct and indirect. Operating profit may also be presented as a percentage value. Operating profit percentage is calculated by dividing the operating profit $ by the revenue from sales $. In the example above the operating profit percentage is 31%.

Now you understand the definitions of gross and operating profit you are ready to analyse these important performance indicators.

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The real income of a business is the gross profit. Gross profit is the balance remaining from revenue when all variable costs have been paid. Variable costs are those specific to the product or service sold - the cost of goods or materials, production costs and the cost of labour to produce or deliver the product or service.

How does gross profit affect my business? Let us look to the following table (figures are ,000s):

There are several ways to increase gross profit as a percentage of income:

• Decrease the cost of goods sold; i.e. use alternate suppliers, or purchase in bulk
• Decrease the cost of production e.g. lower labour rates, improved efficiency in manufacturing
• Increase the sell price of goods or services
• Minimise discounting practices

A combination of changes to the business model are recommended when seeking improved financial performance by increasing gross profit. Analysis should take into consideration not only the direct costs, but also the different products within the product range and the proportion of total sales comprised from each product and the varying gross profit percentages of each product. This next step in analysis of gross profit is covered in another article.

Want more?
Download the Systems Mentors Gross Profit Analysis workbook (Microsoft Excel 2007) and work through the GP exercises with your business data. Good luck!

If this article interested you then you may also like: