The gross profit on a product is computed as:
Sales – Cost of Goods Sold = Gross Profit
To understand gross profit, it is important to know the distinction between variable and fixed costs.
Variable costs are those things that change based on the amount of product being made and are incurred as a direct result of producing the product.
Variable costs include:
- Materials used
- Direct labour
- Plant supervisor salaries
- Utilities for a plant or a warehouse
- Depreciation expense on production equipment
Fixed costs generally are more static in nature. They include:
- Office expenses such as supplies, utilities, a telephone for the office, etc.
- Salaries and wages of office staff, salespeople, officers and owners
- Payroll taxes and employee benefits
- Advertising, promotional and other sales expenses
- Auto expenses for salespeople
- Professional fees
Variable expenses are recorded as cost of goods sold. Fixed expenses are counted as operating expenses (sometimes called selling and general administrative expenses.
While the gross profit is a rand amount, the gross profit margin is expressed as a percentage. It’s equally important to track since it allows you to keep an eye on profitability trends.
This is critical, because many businesses have gotten into financial trouble with an increasing gross profit that coincides with a declining gross profit margin.
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The gross profit margin is computed as follows:
Gross Profit / Sales = Gross Profit Margin
There are two key ways for you to improve your gross margin. First, you can increase your prices. Second, you can decrease the costs to produce your goods. Of course, both are easier said than done.
An increase in prices can cause sales to drop. If sales drop too far, you may not generate enough gross profit rands to cover operating expenses. Price increases require a very careful reading of inflationary rates, competitive factors, and basic supply and demand for the product you are producing.
The second method of increasing gross profit margin is to lower the variable costs to produce your product. This can be accomplished by decreasing material costs or making the product more efficiently.
Volume discounts are a good way to reduce material costs. The more material you buy from a supplier, the more likely they are to offer you discounts.
Another way to reduce material costs is to find a less costly supplier. However, you might sacrifice quality if the goods purchased are not made as well.
Whether you are starting a manufacturing, wholesaling, retailing or service business, you should always be on the lookout for ways to deliver your product or service more efficiently.
However, you also must balance efficiency and quality issues to ensure that they do not get out of balance.
Let’s look at the gross profit of ABC Clothing Inc. as an example of the computation of gross profit margin. In Year 1, the sales were R1 million and the gross profit was R250 000, resulting in a gross profit margin of 25% (R250 000/R1 million). In Year 2, sales were R1.5 million and the gross profit was R450 000, resulting in a gross profit margin of 30% (R450,000/R1.5 million).
It is apparent that ABC Clothing earned not only more gross profit rands in Year 2, but also a higher gross profit margin. The company either raised prices, lowered variable material costs from suppliers or found a way to produce its clothing more efficiently (which usually means fewer labour hours per product produced).
ABC Clothing did a better job in Year 2 of managing its mark-up on the clothing products that they manufactured.
Many business owners often get confused when relating mark-up to gross profit margin. They are first cousins in that both computations deal with the same variables. The difference is that gross profit margin is figured as a percentage of the selling price, while mark-up is figured as a percentage of the seller’s cost.
Related: Should You Ditch Your Annual Budget?
Mark-up is computed as follows:
(Selling Price – Cost to Produce) / Cost to Produce = Mark-up Percentage
Let’s compute the mark-up for ABC Clothing for Year 1:
- (R1 million – R750,000) / R750,000 = 33.3%
Now, let’s compute mark-up for ABC Clothing for Year 2:
- (R1.5 million – R1.05 million) / R1.05 million = 42.9%
While computing mark-up for an entire year for a business is very simple, using this valuable mark-up tool daily to work up price quotes is more complicated. However, it is even more vital.
Computing mark-up on last year’s numbers helps you understand where you’ve been and gives you a benchmark for success. But computing the mark-up on individual jobs will affect your business going forward and can often make the difference in running a profitable operation.