Gross profit is defined by the accounts as revenue less the cost of goods sold (or services rendered). Gross profit and gross margin (gross profit as a percent of revenue) are the great equalizers between different businesses. You could have a $10,000,000 construction business that yields a 10% gross margin or a $1,500,000 professional service business that yields 66.7% gross margin and end up with the same $1,000,000 to cover fixed expenses and return a profit. When I look at a business, the first thing I look at is the gross margin. One of my long-term clients had two businesses. When I first met him, his concern was that one business was returning about 10% net profits, while the other was losing money. The first place I looked was gross profit. The first business was yielding 37% in gross profits. The second business was yielding just 17% in gross profits. When I pointed this out he first started arguing with me. He knew he was marking his services up enough to generate between 25% and 30% in gross profits. When we dug into it, we realized that he had agreed to a stipulation in the contract of his second largest customer that passed through a particular service from an outside vendor at cost. It just happened that in that year, that particular customer consumed a large amount of the service. Know what drives your gross margin and always look to improve it.
Now here’s the secret. Once you know your gross margin, you can use it to evaluate any investment from marketing to expansion, to new equipment to investing in a business coach. You simply divide the investment by your gross margin. Let’s say you have a new investment of $2,000 per month and you have a 50% gross margin. You simply divide your investment of $2,000 by your gross margin of 0.5 which means that you would need $4,000 in new revenue to breakeven on the investment. For every dollar after that, you will drop $0.50 to the bottom line.
Here are my top four ways to improve gross margin:
- Increase Your Price– As discussed in my last BLOG on Average Revenue, increasing your price is the fastest, most efficient way to increase your gross profit. Every dollar you increase your price by will fall directly through to Gross Profit. This will automatically increase your gross margin.
- Stop Discounting– A discount is the same as a price decrease. For certain businesses, discounting is appropriate as long as the incremental demand more than offsets the discount. But remember, every dollar discounted also drops negatively to the bottom line.
- Reduce Your Cost of Goods Sold– As your volume increases, do not forget to renegotiate with your suppliers. I once helped a company reduce their product cost by 23% just by leveraging their volume increases and negotiating with multiple suppliers.
- Improve Your Efficiency – Whether you sell a product or a service, labor is a significant percentage of your cost of goods sold. Implementation of lean manufacturing principles will significantly improve your efficiency. You need to learn and understand the seven types of muda which means waste, where waste is any activity that does not add value. The seven types of MUDA are: 1) Overproduction; 2) Waiting; 3) Transporting; 4) Inappropriate Processing; 5) Unnecessary Inventory; 6) Unnecessary / Excess Motion and 7) Defects.
Every dollar that you increase your gross profit will drop to your bottom line. If you would like to explore how you can drop more to the bottom line, give me a call @ 585-781-0384 or follow the steps below.
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