DO YOU KNOW YOUR GP?
Keeping your business healthy and wealthy ...
Posted by Maureen Windridge on 10/01/2013
In my recent blog post Gobbledygook Be Gone I explained that Gross Profit (GP) could be the subject of a blog in its own right and I promised that I would come back to it. Those acquainted with me will know that I'm a lady who always keeps her promises ...
make sure your finger is on the button - the percentage button
So here we go - and I'll start at the beginning, with the two questions which I ask potential new customers. These questions are:
- What is your GP%?
- What is your Break-even point?
Amazingly, very few can answer these questions - in fact, many don't understand them!
The GP is the difference between the value of sales and the cost of making those sales. These costs include goods purchased for resale, materials for manufacture, direct labour together with the costs directly associated with the sale of the goods or services - these could be salaries and expenses of sales people, sales commissions and advertising and marketing. The GP% is Gross Profit / sales.
For example - a business that sells £25,000 of goods and has and has manufacturing and sales costs of £17,500 has made a GP of £7,500 and the GP% is therefore 30%.
The GP% is important because it enables comparisons to be made between several financial periods and between businesses in similar industries.
The Break-even Point is a calculation of the approximate sales volume required to just cover costs. If sales are below Break-even, the business would be unprofitable and above Break-even it would be profitable. Break-even analysis focuses on the relationship between fixed cost, variable cost and profit. Break-even cannot be calculated unless GP is known, which is another reason why knowing the GP is important.
In most businesses, the GP% stays fairly even from one month to the next and from one financial year to the next. There are exceptions - if a business has a product mix with varying profit margins, some high some low, for instance; a different mix of product sold in one period compared to another can affect the GP comparisons. Most modern accounting systems, however, make it very easy to analyse the mix of products sold and compare these from one period to the next.
Managing GP will help a business avoid problems caused by pricing being too low or Cost of Sales being too high. When a business is generating adequate sales but the GP is low it often signals a problem in one of these areas.
A newly formed bakery was losing money every month, even though it had very quickly gained a reputation for having the best cakes in town. The bakery had reached production capacity and was turning away customers, but was not making a profit. A quick analysis showed the GP was inadequate and in this case prices were too low. The bakery was using the very best of ingredients. Their cakes were a higher quality than any other bakers in the area and yet they set their prices equal to other bakers. The solution was simple - if the bakery were to carry on producing such high quality cakes they had to increase their prices. They had a waiting list of customers and people obviously perceived the product has high quality so this was not a problem.
A florist wondered why she was struggling to cover her costs. Her prices and sales figures were in line with her competitors. Investigation showed her Gross Margin was not in line with industry averages. Further investigation showed that her employees were not being attentive to cost of materials and a lot of waste was being incurred with every bouquet made. Instituting costs and production control meant the owner starting making a profit.
These two stories are quite simple, however they do illustrate how important the calculation of GP is. In both cases the owners did not know their GP% or value. They simply new the business was losing money. This lack of understanding often leads to decisions that worsen the situation, for example "we need to make more money so let's increase sales". Obviously in the two cases above that would also have increased the losses. Even worse a business might decide to increase volume of sales by reducing prices, thus reducing the GP % even further.
GP often does not get the attention it deserves. A new business should be aware of the factors that can impact on their GP and pay close attention to them. Find a benchmark for GP using data on your nearest competitors or use a website which can help, such as www.industry-averages.co.uk.
It is important to track your GP over time to be sure it does not slowly deteriorate and lead to problems with cash flow.
I hope this has given you a quick and easy to understand grasp of GP, however you may well find that it would be helpful to chat the matter through with me in greater detail. As a Bookkeeping in Milton Keynes, I help many local businesses - I'm sure I can help you too! Do call me on +44 (0) 1908 692378 for an initial conversation!
Until next time ...
I consider myself to be incredibly lucky because I am a bookkeeper. At the age of thirteen I did a three year course in three months and passed with distinction. Many years have gone by since then and I am still fascinated by the process of double entry bookkeeping. A process developed over 500 years ago by a venetian monk called Luca Pacioli.
Many people would like a machine that they could put all their paper work into at one end and it would come out the other end all sorted totalled and balanced. I'm glad it hasn't been invented because it would take all the fun out of my work!