Friday, March 9, 2012

Maximising Your Gross Profit - Your Key to Business Success!

Speak to many retailers and they will tell you that business success is measured by the growth in sales achieved over a specified period. Whilst there is no doubt that sales growth is a critical factor in any healthy business, it's the growth in what you make out of those sales that is the true barometer of success. It's with these dollars that you have the ability to pay your running expenses, repay loan principal, draw a wage and pay any income taxes on your profit.
When cost of sales are deducted from sales, the result is the gross profit of your business. When gross profit is divided into your sales, the result is your gross profit margin. Although it is critical to review your expenses on a regular basis to ensure each type and amount of expense is adding value to your business, it is focusing on your gross profit and gross profit margin that will provide you with the biggest impact on profitability.
Utilising my 5 pillars of profit improvement model, the subject of a future paper, proves that focusing on gross profit/margin improvement can be 40% to 300% greater than focusing on just expense cutting.

So, in summary, gross profit and gross profit margin are calculated as follows:
Sales                                                                                      $2100000
Less Cost of Sales                                                                    672000
Gross Profit                                                                            1428000
Gross Profit Margin (Gross Profit/Sales)                                32%
 

Cost of sales is calculated as follows: 

                                 Opening Stock

Plus                         Purchases

=                              Total Value of Stock Available


                                 Total Value of Stock Available

Less                         Closing Stock

=                               Cost of Goods Sold 

The value of your ‘Opening Stock’ is the total value of all the goods you have in the store, on the shelves and in storage (valued at cost), at the beginning of the period. Similarly, your ‘Closing Stock’ will be the value of all goods you have in the store at the end of the period. These are calculated by doing a physical ‘stock-take or, if you have a reliable stock control system, the value of stock as calculated by the system.’ ‘Purchases’ are the value of stock which arrived into store during the period (but not necessarily paid for). 

It is fair to point out here that the adoption of technology including computer accounting systems has "dumbed down" in many cases the ability of a business owner to really understand and interpret what is happening in a business. The mindset that if the computer says it, it must be right is one of the prices paid in today's technological driven world. This is one of the reasons why I have chosen to write this paper. 

So, the first step in Gross Profit improvement is actually to determine what it really is. If you have a reliable point of sale and stock management system, then this should be a relatively simple task. However, there are many factors that may result in the real gross profit being less than what your point of sale system indicates - and these will become more relevant later in the paper. 

Thus the calculation of the true gross profit margin is dependent of a number of critical factors including: 

·         Correct recognition of sales. Sales must be recognised when they are made, not when money is   
 collected. Therefore, an accurate balance of accounts receivable must be known as both the start of
 the assessment period and at the end. Sales will be recognised net of any discounts given to
 customers.

·         Correct recognition of purchases. Purchases must be recognised when the stock is received, not when it is paid for. Therefore, an accurate balance of accounts payable must be known as both the start and end of the assessment period.

·         Correct calculation of Opening Stock at the start of the assessment period and Closing Stock at the end of the assessment period. In a physical stock take sense, the means that:

- All stock is counted that has been included in purchases which has not been sold

- That the stock has been valued appropriately, net of discount. (Note: The ATO require the
   value of stock to include the appropriate share of freight costs inwards!)

Any damaged or obsolete stock should be valued at nil or realisable value, if considered to be worth below cost. 

Strategies to Improve Your Gross Profit 

Areas that will directly affect your Gross Profit include: 

I.           Shrinkage

2.          Stock Control and Buying

3.          Pricing and Discounting

4.          Sales Mix (or the mix of sales between higher profit items to lower profit items)

1. Shrinkage
 

‘Shrinkage’ refers to stock that you have purchased and paid for, but have not sold. So, there can be no return those purchases. Shrinkage occurs due to a number of factors, both internal and external to your business, including:

Poor Purchasing Systems (goods inwards) -  when all your purchases are not accounted for. Things to consider include:

       -    Have you actually received what you have been invoiced for?

       -    Have you negotiated the best buy price?

       -    Have prompt payment and other discounts been claimed and credited?

       -    Have you been charged the correct amount by your supplier?

       -    Have faulty goods been returned for credit?  Has the supplier credited you for the returned
            goods?    
      

Shoplifting (or goods taken for personal use) - you need to be aware of three areas:

-     Team

-    Business Owners

-    Customers

-    Other members of the public 

Damage

-   Poor handling in store or transit resulting in stock being damaged in-store

-   By customers in store


Helpful pointers to reduce stock shrinkage:

          -   Establish a purchase order system

-   Check invoices to order

-   Check deliveries to invoice or delivery dockets

          -     Have a system for stock deliveries

          -     Secure your loading bay and stock storage areas

          -     Record stock drawn for personal or team use

-     Minimise damages:

   In receiving

   In handling

   Return damaged goods and claim credits

-          Ensure you have good cash security at Points of Sale and that all sales are ‘booked’ out

-          Have good awareness of customers and timely ‘welcome’ or approach on their entering the store

-          Have adequate staffing levels

-          Implement a stock control system and undertake rolling stock takes 

2. Stock Control and Buying  

‘Stock Control’ involves being aware of your stock levels, knowing what’s selling and what isn’t, so as to know what, when and how much stock should be re-ordered. Knowing what is or isn’t selling allows you to take advantage of special ‘buys’. When you do your buying, you should plan to reduce irregular orders, the cost of freight, handling stock and at the same time, try to maximise stock turnover. Knowing your stock turnover and managing it properly can make a significant difference to your cash flow. For example,  a business turning over $2m with a gross margin of 32% and a stock turn of 4 times would be able to release $68000 of cash by increasing stock turns to 5 times - by reducing stock to $272000. 

For effective stock control, a system needs to be in place to co-ordinate both your stock and team in the purchasing process. Various  computer systems are available and should be assessed. However, the value of such a system is only as good as the information that goes into it so establishment and adherance to set procedures is a must to ensure the integrity of the information produced.

3. Pricing and Discounting 

When pricing your products, the difference between ‘mark-up on cost’ and ‘gross profit margin’ should be fully understood. Misunderstandings in these concepts can have a devastating impact on your profitability - and you would be amazed how many business owners get this confused. To demonstrate the possible impact, let's say the you are targeting a 35% gross profit margin. You incorrectly confuse this with mark up and mark up 35%. Let's compare the difference (for the sake of this example, ignore GST): 

Purchase Price                                  $100

Mark Up @ 35%                                     35

Sale Price                                                135

Cost                                                          100

Gross Profit                                            35

Gross Profit Margin                            25.9% 

To obtain a 35% Gross Profit Margin, the product would need to be marked up by approx. 54%. The result would be: 

Sale Price                                             $154

Cost                                                         100

Gross Profit                                              54

Gross Profit Margin                            35.0% 

This is a difference of $19 or 54% on your gross profit margin, which impacts on the bottom line profit by that exact dollar amount!

By discounting, we cut the price of a product. Businesses faced with increased competition are increasingly resorting to price cutting in a bid to lift sales volume. Basically there should be three reasons for discounting: 

1.        to sell old or slow moving stock

2.        to boost overall sales volume

3.        to increase store traffic by having a loss leader or sale item 

When you cut the price of a product, you also reduce the Gross Profit Margin, so discounting should have a definite purpose and be supported by strategic merchandising and selling systems.

There are discount table available that show you the effect of cutting price and the corresponding increase sales volume that you would need to achieve to maintain the same total gross profit dollars. I can supply a copy if you request one in comments.

Example from the discount table (All assumed GST Exclusive):

A cut in price (discount 10%) - previous gross margin = 

                                                                    Case One                                                Case Two

                                                                  Before Discount                              After 10% Discount                        

                                Sales                    (500 x $100) = $50,000                    (500 x $90) = $45,000

Less                        Cost                      (500 x $80  ) = $40,000                    (500 x $80) = $40,000

Equals                   Gros                                                 $10,000                                              $5,000

                                Gross Profit Margin                       20%                                                    11.1% 

After discounting by 10% in Case 2, the sales price of the item is now $90. If total units sold stays at 500, then you will only make a total gross profit of $5,000, not $10,000 as in Case 1. To achieve the same total gross profit of $10,000, you will need to sell twice as many units (ie 1,000) in Case 2. The discount table referred to earlier shows the percentage increase in units required to sell to maintain the same amount of total gross profit on a product after discounting.

Pricing really is an art, not a science. One big mistake that many business owners make is using
standard mark ups to determine a price. This may mean that opportunities for 200%-1000% or more mark up on some stock items may be missed with the result that valuable gross profit dollars are lost. Also remember that being aware of price points can make a big difference to gross profit dollars. There is a saying that the customer owns the first numbers in a price - the last numbers belong to the business owner - so use this information strategically to maximise your gross profit.
Most business owners spend too little time developing pricing strategies - this is a grave error as getting your pricing right can be 3 times or more effective on profits that simply cutting costs.
Gross Profit Margin Vs Gross Profit Dollars
In general, your aim is to maximise your gross profit margin. However, there will be some circumstances where gross margin will be sacrificed for gross profit dollars. This needs to be a strategic decision with consideration given as to whether the sacrifice in margin to gain gross profit dollars will be offset by an increase in expenses eg wages.
To give an example - say your business has an average $ sale (excluding GST) of $50. Assume you make 20000 sales a year - this gives you sales of $1000000. Assume your average gross profit margin is 35% or $17.50 per sale ($50 X 35%).
If an opportunity came along to make a sale of $20000 at a margin of 10%, should you do it? If you had a total focus on gross profit margin, you would reject it. However, looking at it a different way, assuming there were no additional costs in making the sale, the sale would generate $2000 gross profit ($20000 X 10%). Now, at your normal average dollar sale of $50 and gross margin of 35%, the $2000 gross profit on the opportunity equates to the equivalent of 114 sales ($2000/$17.50) - now that decision may become a little clearer.
The moral of the story is that although maximising gross profit margin is an important strategy, in the end, your expenses, principal repayments, income tax and drawings are paid from gross profit dollars!
4. Sales Mix 

The reduction in gross profit by discounting selected items can be offset by carefully placing associated ‘add-on’ products near the ‘sale’ item. Good store layout, combined with good product knowledge by your team and effective, customer focused selling systems can improve your Gross Profit dollars. With use of effective displays, team selling skills and product knowledge, the mix of sales can be altered to maintain or enhance your Gross Profit. Brain storming with your team as to logical add on sales for your major product lines will ensure your customer experience is enhanced. 

Gross Profit can also be positively impacted by the introduction of services. These generally are high margin but you need to be conscious of the costs involved in delivering these services. That is because the expenses directly linked to services appear as overheads rather than cost of sales.

Summary

In today's competitive environment there is relentless pressure to commoditise retail. It feels like a race to the bottom as more and more competitors enter the market with discounted products. The major problem with this strategy, apart from diminished gross profit margin and dollars, is that it is the easiest strategy to copy - and unless you have a true cost advantage, the impact on profit can be devastating. 

To succeed in these most challenging times, you must continue to innovate, test and evaluate products, services and most importantly the customer experience you deliver. These times, more than ever, you must work on your business to find ways to differentiate your business and service offerings from your competitors. 

And one final tip - look outside your industry for inspiration. This is where you will find ground breaking ideas that, when adapted to your business model, may result in continued business success. And remember, the when you have your business in perfect shape, it is possibly at is most vulnerable - keep searching for positive change at all times as there is always a better way to do things. Remember, business is a journey!

2 comments:

Mark Martin said...

Hi! Thank you so much for sharing this interesting and informative post! You have such a great idea about this. This could help me out if I'll apply it to my business. I'll be looking forward for your other posts as well. Keep it up! In a small firm, an accountant may be responsible for keeping all financial records. These records include payroll information, accounts payable, accounts receivable, retail sales, and information regarding investments held by the company. These accounts are kept organized in ledgers which are used to asses the financial health of a company. Ledgers are always kept up to date, and may be consulted by managers and high ranking members of a company when they are making major business decisions. Do you have the expertise and the time to setup your business accounting system with accurate liability and expense accounts? Your business information needs to be precise and up to date. All your hard work and focus on your business leaves little time or energy for these daunting tasks. Accountant in Framingham MA

Chris Foster said...

Hi Mark
Thanks for your feedback. I feel as accountants that we have an obligation to educate clients - not just prepare tax returns. Educated clients make better business decisions, grow and become better clients!
That said, most small business clients have relatively poor record keeping systems and really don't know what their financial performance is really like - until their accountant prepares a tax return months after year end. And most accountants don't spend the time to explain the financial results and therefore proactively offer value added services - a pity really!
Watch out for my next post over the next few weeks
Cheers
Chris