What the Gross Profit Story Hides About Your Company?

What the Gross Profit Story Hides About Your Company?

discover | Saturday - 01 / 06 / 2024 - 6:13 pm

Perhaps you have been experiencing a decline in your profit margins over the years, or perhaps you are experiencing the worst-case scenario, which is that you find that no matter what you do, your profits do not increase proportionally with your revenue growth.

In today’s blog post, we will not talk about increasing revenue or profits (each separately), but rather we will reveal the real secret to profitability, which is to set a total profit target and use it to cover all your company’s expenses.

Are net profit and gross profit the same thing?

Short answer: No, not exactly… Let me explain in a bit more detail:

Gross profit is the profit that remains after subtracting the cost of goods sold (COGS) from net revenue (often called sales revenue). In other words, sales of a particular product/service minus your direct expenses associated with that product/service [including direct expenses, direct labor, and raw materials] is the gross profit for that product or service.

Net profit, on the other hand, is obtained by subtracting indirect expenses from the gross profit of all products/services [indirect expenses: all fixed overhead expenses: rent, supplies, and salaries of administrative and support staff; all of which are not directly related to a product, service, or client].

Here, a question might arise in your mind:

“Well, maybe they are not the same thing, but they both share a connection to expenses, right?”

I know what is inside your head: If you reduce expenses, both net profit and total profit will increase. This is the trap that business owners fall into! These reductions have positive effects, but they are short-lived (there are negative effects on future revenue generation, and these negative effects will appear after a year or more). Therefore, it is unlikely that the increase in net profit and total profit will be sustainable.

Let’s explain this with an example: It is common for business owners to adopt the traditional business strategy of:

– Closing as many deals as possible at attractive starting prices.

– Using the cheapest possible resources.

– Creating as many task orders as possible during the project.

– Trying to retain the client by “customizing the product or service” so that it is difficult for clients to replace your company.

– Trying to take advantage of the client in the long run.

Based on our experience at Logix, this strategy typically works well for a few years, but is followed by challenges in the remaining years.

The downside of this strategy is that it creates a higher proportion of dissatisfied clients who accumulate requests for assistance and support. After a while, some clients will eventually switch to other companies.

In addition, the continuous increase in revenue is not sustainable as there is a limit to the market size and market share for the same product.

This traditional strategy may be successful in a growing market where you can replace lost clients with new ones, but ultimately, growth will slow down and competition will intensify as more competitors enter the market (including competitors who can offer lower prices).

The alternative towards Increasing Gross Profit Margin:

I’d like to propose an alternative approach to boosting gross profit margin, one that has been successfully implemented by numerous businesses for years in slow-growth, highly competitive markets.

To begin, the best way to assess your profitability is to track your gross profit margin, which represents your total profit expressed as a percentage of revenue.

The gross profit margin is calculated as follows:

(Total Profit ÷ Revenue) × 100 = Gross Profit Margin (%)

Monitoring your gross profit margin percentage is the most effective way to track a company’s profitability. This is because while your revenue may be growing, your overall profit may be shrinking, and you won’t be aware of this unless you see the relationship between the two as a percentage.

Since gross profit is derived from revenue and costs/ expenses, to increase gross profit margin, you should focus your attention on two areas:

– Increase revenue by selling at a higher price.

– Reduce unnecessary costs (or those with a minimal impact on profit generation).

It seems easy, right?

But easy doesn’t always mean simple. Let’s delve a little deeper:

Selling at a higher price:

Many business owners fear that raising prices will lead to losing clients and reducing company’s sales. For this reason, we always recommend that you let your clients set the pricing strategy themselves!

And please, don’t underestimate the importance of being able to sell at a higher price. If we assume that the total profit margin for a sale is 50%, raising your price by 10% will increase your total profit by 20%. Conversely, you would reduce your total profit by 20% if you offered a 10% discount.

Your ability to sell at a higher price means you can reach your break-even point with fewer sales.

Reducing costs:

Do you know your marketing and sales costs per dollar of revenue?

To increase your overall profit margin, you should strive to achieve more revenue with fewer resources; these resources include sales and marketing resources.

By answering the following questions, Logix financial management system helps you analyze the (sales cycle) that includes attracting potential clients (leads) and converting them into permanent clients:

– Do you know how much it costs you to generate a qualified lead?

– Are your current marketing tools and campaigns effective?

– Are you sure that telemarketing is the best way to market?

Therefore, having a marketing strategy that focuses on the target market is considered essential.

Your Trusted Assistant:

Achieving the above-mentioned goals becomes challenging without proper project execution. Consider these scenarios:

– How often do your employees rush through tasks manually, only to spend time later correcting errors?

– What about recurring support issues that require constant effort to resolve? Do these situations sound familiar?

These continuous rework efforts can jeopardize your profit margins, leading to lower profits (or even losses).

Strong resource management, a well-defined project execution methodology, robust implementation, enhanced technical support management, and problem-solving capabilities can help you overcome these challenges.

So, what story does gross profit tell?

Both gross profit and its margin measure how well your company uses its resources in the area of providing a product/ service. Typically, the higher the gross profit margin, the healthier your company is financially.

However, the company’s industry and products also affect gross profit margin ratios. For example, in service companies, where employee time is the product, gross profit margins are higher on average than in other industries. This is because there are no direct material costs to be deducted from sales.

By tracking gross profit margin on a monthly basis and comparing it to your target gross profit margin, you can red flag problems and spot trends. The change in gross margins gives you insights into product/service, customer, or company-related issues.

Gross profit margin provides insights into:

– Cost overruns.

– Poor pricing decisions.

– Profitability trends.

Enhance Your Company’s Profitability by Choosing the Optimal System:

Beyond spreadsheets and numbers, total profit is the compass that guides your profitability. Imagine it as a behind-the-scenes step to understanding your company’s financial performance.

By tracking total profit, you have a better view of the company and can see where your company is making money (and where it is not). With this information provided by the Logix financial management system, you can make better decisions (I mean decisions that directly affect your company’s profitability).