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):

P&L Statement				Balance Sheet					The table represents a poorly performing business with respect to profitability. Although the business turns over $1.7M in sales each year, the high cost of labour erodes the revenue, producing only 35% gross profit. Many business owners may try to increase turn over to improve the business bottom line. However, assuming gross profit persists at 35%, the turn over required to simply meet the business expenses and liabilities is $3,057,143 - that is 180% of the current income!
Income		1,700
Materials	150
Labour	950
Direct Costs		1,100
Gross Profit		600
Indirect Costs		450
Operating Profit		150			Profits Banked		150
					Liabilities		620
					Cash at Bank		-470

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

To examine the effect of these methods to improve the business profitablity let us re-examine the financial data after: 1. Increasing the selling price of goods by 10% 2. Decreasing the cost of labour by 10% Without any increase in the volume of sales, these changes have resulted in a gross profit percentage of 46% and vastly improved the overall profitability of the enterprise.		P&L Statement				Balance Sheet
		Income		1,870
		Materials	150
		Labour	855
		Direct Costs		1,005
		Gross Profit		865
		Indirect Costs		450
		Operating Profit		415			Profits Banked		415
							Liabilities		608
							Cash at Bank		-193

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!

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