Many business owners struggle to gauge their performance in terms of gross profit. They wonder whether they are doing well compared to their competitors or what a healthy, successful range might look like.
This month’s post will discuss different variables needed in considering how much gross profit a business should be making. So if you’re ready to understand and positively adjust your gross profit, this article’s for you.
Getting Started— What is a reasonable gross profit margin for my business?
Two important places to start when establishing a gross margin goal for your business are 1) the industry average and 2) the life stage of your company.
Let’s take a look at why:
The industry average
Do you know what the gross profit margins are within your industry?
If you don’t, consider starting there. Gross profit margins may fluctuate drastically between industries, so you’ll need to do some market research to get an idea of what other businesses in your industry are achieving in order to get a ballpark range for a healthy gross profit margin. Start by looking up public financial information for companies in your industry, or use Ready Ratios to get averages by industry.
Your company’s life stage
The life stage of your business plays a significant role in your gross profit margins. For example, if you’ve just recently opened your doors, you’re unlikely to be hitting record-high GP percentages rates.
Start-ups require upfront costs that are considered to be investments for the future. That means accepting a lower-than-average GP percentage to start with. Mature companies, on the other hand, can take industry GP% averages at face value, and use that information to build goals and plans for the future.
Once you’ve collected industry data and adjusted it for the life cycle of your company, you’ll have good insight as to what a healthy gross profit margin will be for your business.
Next, you’ll need to calculate your current GP percentage and compare it against that healthy percentage goal you just created.
Calculating GP Percentage
Some say a healthy GP percentage is one that covers your fixed costs and still leaves you with a healthy net income that meets your expectations for returns on your investment. This requires a few simple calculations.
Of course, the keyword here is expectations. Net income goals differ depending on the expected returns on investment by the owners. Generally speaking, a solid and healthy net income goal is 20% of revenues for a mature company. Keep in mind, this will vary by industry.
Once you have your Net Income goal, consider your fixed costs. These are costs that don’t vary based on increases or decreases in revenue. Examples of common fixed costs are rent, insurance, and payroll. If your gross profit is just covering your fixed costs, you are in effect, breaking even.
Adding your expected net income to your fixed costs will give you your required gross profit. From there, divide your gross profit by your expected revenues to get your expected Gross Profit Margin. In other words:
Gross Profit Margin = (Sales – Cost of Sales) / Sales
Let’s say your net income goal is $200,000.
Next, add in your fixed costs (rent, insurance payroll, etc).
Let’s say that’s $500,000.
That means you need $700,000 in gross profit to cover your fixed costs and hit your net income goal.
Now if your GP% has historically been, say, 50%, then you know you’ll need twice that amount, in this case, $1,400,000 in sales to get there. But if your GP% is closer to only 40%, you’ll need $1,750,000 in sales to get to the same place.
How to reach your desired GP%
If your GP% is low compared to the industry average, work to adjust it by:
- Increasing your revenue. That seems obvious, but what’s not so obvious is how to increase revenues. Revenues are a product of quantity and price. You need to increase the quantity you sell, increase your price, or both. Quantities can be increased by selling to new customers, selling more goods and services to existing customers, or both. You can also grow your top-line revenue through acquisitions, entering new geographical areas, or even expanding your product and service offerings. Prices can also be increased in a number of ways using various pricing strategies depending on your market.
- Reducing your costs. Similar to the above, costs are also a product of quantity and price. To reduce costs, you’ll need to reduce the quantity you buy, reduce the price you pay, or both. For example, in service industries, this might mean focusing on maximizing efficiency and productivity to reduce headcount while servicing the same number of customers.
Many business owners worry about their gross profits without having any idea what healthy ranges within their industry resemble or what they ought to expect.
The above steps are simple ways to gauge and understand your performance within your industry’s standards, as well as in comparison to your own goals.
Keep in mind, your company’s life stage can also skew your gross profit margin if you’re just starting out, but forecasting what you would like to see on your income statement can be a vital first step in implementing measures to achieve your desired GP%.