Focusing too much on Gross Profit Margins may actually be hurting your net profits. Gross Profit Margin is a key metric that shows how well your business is performing. It is calculated by dividing gross profit (which is the difference between net sales and cost of goods sold) by net sales, then multiplying by 100 to get a percentage..
For example, if your monthly sales are £25,000 and your cost of goods sold is £10,000, your gross profit would be £15,000 (£25,000 – £10,000). This means your gross profit margin is 60% (15,000 divided by 25,000 * 100).
Gross Profit Margin can help you assess the efficiency of your business and compare it with others in the same industry. By monitoring it monthly, you can quickly spot any issues or pricing adjustments that need to be made. Consistency in margin is key, so any decrease could signal problems such as increased raw material costs not factored into your pricing, higher labour costs, waste, overtime, or errors in costing.
On the other hand, an increase in margin could suggest lower material costs, efficient labour, less waste, deliberate pricing strategies, or even errors in costing. By analysing these variances regularly, you can take prompt action to address any issues and optimize your profitability.
Numerous businesses, such as engineering firms or printing companies that cater to customized or one-time projects, often assess the gross profit margin on a job-by-job basis. For instance, a printing company I once collaborated with would evaluate the gross profitability of every job. Then, during monthly production meetings, the three most profitable jobs and the three least profitable jobs would be reviewed. This allowed the entire team to not only analyse jobs that didn’t make the expected margin but also jobs that exceeded the expected margin. This would enable them to learn from both scenarios. Many companies will analyse what went wrong but fewer analyse what went well.
Ultimately, the objective of any business is to generate profit, below I share two real-life examples of companies I have worked with, where a relentless focus on maintaining a specific gross profit margin was hindering their overall profitability.
Case Study 1: The company in question operated as a middleman in the business to business market, buying products from one supplier and selling them to another. The Managing Director of the company placed a high emphasis on ensuring a gross profit margin of at least 50% on all sales. One of the company’s product lines involved providing solar-powered lights for runways and airfields. They would obtain these lights from a leading supplier at a discounted rate of 10%, add their markup, and then sell them to customers.
When a medium-sized airport expressed interest in completely outfitting its field with solar lights and the necessary controller, the company saw an opportunity. The lights were reasonably priced, so achieving the 50% margin was not an issue. However, the stumbling block was the controller, which had a price tag of £500,000. To maintain the desired margin, the company would have had to sell it for £900,000, making it uncompetitive in the market.
I proposed a different approach, suggesting that they sell the lights with a 50% margin, but offer the controller with only a 10% margin. This strategy would have still generated a gross profit of £170,000. Unfortunately, the Managing Director was insistent on quoting the controller at £900,000, ultimately losing the lucrative order.
Case Study 2: The second company in question was a small engineering firm that specialized in creating customized parts using lathes and CNC routers. They were not fixated on attaining a specific gross profit margin but aimed for 45% whenever possible. With 3 machines and 3 operators, they should be billing around 800 hours per month.
When brought in to assess their costings and profitability, I found that they were achieving an average gross profit margin of 40%, converting only 33% of their quotes into orders, and billing around 205 hours per month. Their monthly net profit was around £3,000.
To improve their performance, I suggested granting the quoting team the flexibility to adjust the gross profit margin based on factors such as the shop floor’s workload, the type of job, the level of difficulty, the customer, and the lead time. The team was allowed to set the margin anywhere between 30% and 55%.
After a three-month trial period, the gross profit margin dipped slightly to 35%, but the conversion rate of quotes into orders rose to 65%. Billed hours increased to 500 hours per month, and the net profit was up to £5,000 per month.
Summary
In business, the gross profit margin serves as a valuable metric for making comparisons and identifying areas of success or failure. However, solely focusing on attaining a particular margin can have negative implications on your overall net profit. It is important to strike a balance and not become overly obsessed with meeting a specific margin target.