Whether you are a manufacturer, a distributor, reseller or service company, knowing how much money you make on each product, product line, revenue stream, channel, contract or customer is critical to maximizing your profitability. Simply put, if you don’t know the Gross Profit margin for one or more of these views (and which of those views is most important varies by industry and company), you are driving blind on your path to profitability and/or maximum profitability.
Let’s start with an explanation of what gross profit is using an example of a reseller/distributor/wholesaler with two major product lines.
If it sells Product line A for $100 per unit and if it buys each unit for $65, its gross profit, on direct costs, is 35%. We get that by subtracting the cost of $65 from the sales price of $100 and then dividing by the sales price of $100.
For Product Line B, it sells for $250 per unit and buy for $225. Using the same math, the company’s gross margin on Product Line B is 10%.
Would you rather sell one unit of Product A at $100 or one unit of Product B at $250? If you’re focused on growing sales, the answer is B, but the sale of one unit of Product Line B only generates $25 in gross profit while the sale of one unit of Product Line A generates $35 in profit.
So, I ask again, would you rather sell one unit of A or one unit of B?
With a focus on gross profit (and ultimately total profit,) I would choose to sell one unit of A and make $10 more than selling one unit of the higher priced Product B.
If this company were currently selling 1000 units of Product A each month and 1000 units of Product B each month, its revenue would be 1000 x $100 = $100,000 plus 1000 x $250 = $250,000 for a grand total of $350,000 in sales. How can we use what we learned about Gross Profit to help this company increase its Gross Profit (and ultimately net profit)?
Assuming the same amount of sales effort (salespeople, marketing, etc.) is required to sell the same number of units of each of A and B, what if they changed their sales and marketing efforts to sell more of A? Let’s say that they set a goal to sell 1500 units of A and 500 units of B (the same total number of units.) The revenue at that goal would be 1500 x $100 + 500 x $250 = $275,000. That’s a decrease of $75,000, but let’s look at how Gross Profit changes.
In the original scenario selling 1000 of each, the company generates gross profit of 1000 x $35 + 1000 x $25 = $60,000. Looking at the second scenario where revenue decreases by $75,000, gross profit would be 1500 x $35 + 500 x $25 = $65,000. Thus, with a $75,000 decrease in revenue they’ve increased gross profit by $5000 or about 10%.
There is much more than can be done with gross profit/margin analyses from looking at it by customer, revenue channel or specific contract. One can also incorporate indirect costs (e.g. people who help provide or support the product) as well as look at the impact on commissions which are not normally considered part of gross profit but are variable cost.
If you have any questions or need any help looking at gross margin for your company, please do get in touch with me a llevy@CFOoptionsinc.com.