Over the years, I’ve read a thousand plus business plans for business plan competitions, investment or client acquisition purposes. By habit, I scan the first few pages of an executive summary and then turn my attention to the financial projections. If I don’t see strong gross profit margins, I start to lose interest in the plan.
Why? Simply stated, lower gross profit margin companies are riskier companies to manage, own or invest in than higher gross profit margin potential companies. This is true for any size business operating in any industry from Silicon Valley to Apalachicola, Florida.
If you work hard to improve your company’s gross profit margin performance, your business will be less likely to end up in bankruptcy court. You’ll have more operating flexibility to survive harsh recessions or the sudden loss of a big customer. And, perhaps best of all, companies with higher gross profit margins than their competitors tend to be bought out for nifty premiums. That’s success.
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How Do You Calculate Gross Profit Margin?
Calculating your company’s gross profit is really easy. Simply add up all your company’s revenues or sales received during a period of time (usually over a month, a quarter or a year) and then subtract the direct costs associated with producing the goods or services sold. This calculation does not include advertising costs, sales commissions, accounting, legal, etc. If you sell candles on Etsy, cost of goods sold includes the wax, wick, fragrance, packaging and labor to produce and ship the candle.
Total Revenues – Total Costs of Goods or Services Sold = Gross Profit
Next, let’s transform your company’s gross profit number into a percentage, which is called a gross profit margin. To calculate your company’s gross profit margin, divide your company’s gross profit by your company’s total sales.
Gross Profit / Total Sales = Gross Profit Margin Percentage
You can compare a company’s gross profit margin performance to other industry competitors on a month-to-month, quarter-to-quarter, or year-to-year basis. If for example you want to start a hip beverage business, look to The Coca Cola Company or Monster Beverage Corporation for margin guidance. Both companies consistently deliver gross margins of about 60%.
An upstart beverage company limping along with gross profit margins in the twenties just won’t cut it for long in the beverage industry. Sure the company might stay in business for some time, but it will struggle because it won’t have enough extra cash flow to fund marketing, new product innovations or other business needs. And, when a company’s projected gross profit margins are too far below industry competitors, investors are hard to find.
Here are three ways you can use gross profit margin analysis to super-charge your business startup or Plan B turnaround:
Know your industry.
Whatever you want to sell, learn what success looks like within your industry. If your dream is to produce custom-built motorcycles, check out Harley Davidson. Its gross profit margins range between 34% and 36%. Aim to beat Harley Davison! If you want to market a consumer or beauty product, do everything you can to get your company’s gross profit margins to 60% to 65%; higher if you are selling perfumes.
New product development.
To the extent that you have a long list of products or services you would like to sell but are short on cash resources, favor the higher gross profit margin opportunities first. Set minimum gross profit margin targets to guide new product or service development too. And never ever sell any product or service with a negative gross profit margin. Your purpose is to make money in business, not lose it on every sale
Specialize at something.
Every business should offer at least one item or service that can be sold at a premium price to boost overall gross profit margin performance. Ideally, this special item or area of expertise becomes what your business is “known for.” The simple objective is to pick one thing and do it really, really well. Build buzz around the item or service too. A diner can market its specialty brownie Baked Alaska; a graphic designer can become known for corporate logo design; a hair salon can specialize in correcting hair color nightmares. The goal here is to market something exceptional that customers will talk about and value.
Don’t despair if your company’s gross profit margin performance today is below your local competitors or industry averages. But do take steps to improve this important metric every year you are in business.
You CAN do this. I know you can.
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