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.
Related: Common Budgeting Mistakes to Avoid
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.
A Strategic Approach To Enterprise Cost Reduction
During periods of uncertainty, companies that take bold action can recover more quickly and gain sustainable competitive advantages that boost performance both in good times and bad.
Companies in South Africa face a number of challenges that include slow Gross Domestic Product (GDP) growth, high unemployment and uncertainty associated with the current political environment. The tsunami of change driven by digital disruption as a result of the fourth industrial revolution has spread across the continent, potentially reshaping the competitive landscape in all regions. To tackle these complex and varied challenges, many South African companies may need to pursue cost reduction more aggressively.
Overall findings in Deloitte’s Strategic Cost Reduction Survey launched earlier this year found that South African companies cited “macro-economic concerns and recession” as a top external risk much more frequently than the European Union (EU) average (59% versus 34%).
Compared to European companies, South African companies posted worse historical results with over 40% of respondents stating that revenue has either remained the same or decreased over the past 24 months.
The survey found that the dual margin approach has been the norm for South African companies with cost reduction targets set very high and even higher cost program failure rates. One question to ponder is whether executives in the South Africa have subconsciously accepted the barriers and scaled back their cost reduction actions accordingly – even if a more aggressive approach to cost management could help their businesses thrive? During periods of uncertainty, companies that take bold action can recover more quickly and gain sustainable competitive advantages that boost performance both in good times and bad.
Re-examining the strategy
Before designing a cost reduction programme, make sure your overall business strategy is still relevant within the current environment. Organisations transform their business for different reasons. Some are positioning themselves for new growth opportunities while others are restructuring to improve efficiency and reduce costs. What they have in common is the desire to dramatically improve their business performance.
Cost reduction programmes are commonly carried out in silos, without much more coordination than each having some portion of an overall rand target to meet. The task then becomes so complicated and fraught with sensitivities that little happens in the way of sustainable efficiencies. But it needn’t be so. If you go to the trouble of mobilising for cost reduction, you might as well make it stick, and create some competitive advantage along the way.
Traditionally, a company bases its strategy on its best prediction of what events could affect its business, and when. But in a fast-changing business environment, you need an approach that doesn’t require you to pretend to have a clear picture of the future. One way to do this is to define a range of scenarios of what the future may hold. Then, develop the best strategy to respond to each scenario. Initiatives that make sense only for certain scenarios become your “contingent strategies.” Once you formulate the core and contingent strategies, your cost reduction program will have to be just as flexible.
Establishing a cost base
A cost reduction programme is only as good as the data it’s based on. You need detailed cost data to identify which factors are driving business costs, as well as to justify cost reductions. The next step, therefore, is to figure your current cost baseline. The cost baseline indicates the costs you would incur if you took on no new cost reduction initiatives and with a cost baseline, you can measure the effect of your cost reduction programme by comparing actual costs to the expenses that would have occurred without it.
Start by updating the current year’s budget to reflect any new efforts, such as staff changes or the introduction of new products. This is a good time to cancel anything that cannot be resourced or no longer supports your strategy. Next step is to analyse your costs and headcount by business line, function, and location. Clearly state any rules for allocating centralised functions or shared services to individual lines of business.
While you’re doing this, try to figure out how your business came to have the cost structure it does. It probably is a product of many leadership regimes and acquisitions. Understanding the history can help you identify promising areas for cost reduction. Assess how each areas performance compares to that of best-practice organisations. If there’s a gap, determine how much you’d need to improve in order to close it. At the end of this project, you should have a decent sized list of potential cost reduction initiatives.
Set Cost Reduction Targets
One way to establish cost reduction targets is to try looking at them from several perspectives, such as:
- Contribution to Strategy – How the initiative will affect your strategic goals and impact on business Continuity.
- Investor View – This is how much cost cutting you need to do to support your current share price, assuming revenues stay flat. If you look at cost reduction from all three perspectives, you can triangulate them to set a cost reduction target that’s both achievable and acceptable to investors. Competitive View – Tally how much you need to save in order to become as efficient as the top performers in your industry. Knowing what your peers have achieved can give you an idea of what you can achieve.
- Operational View – Looking at each line of business to identify potential cost savings, and then aggregate them across the company.
- Ease of Implementation – Identifying whether there are any technical or cultural obstacles to implementation and how you deal with them?
- Risk – In terms of how significant are any implementation risks?
Companies that are able and willing to make bold cost moves could find that the current economic environment is a prime opportunity to position themselves for long-term success. Tactical cost actions alone will likely not be able to deliver the required level of cost savings. Companies need to adopt new approaches to cost management, shifting to actions that are more strategic and structural, such as increasing centralisation, reconfiguring the business, and outsourcing/offshoring business processes.
4 Ways To Improve Your Budgeting Skills
Increasing revenue isn’t solely dependent on how much money your business is making but also relies heavily on how well you manage it.
Traditional budgeting methods have undergone a digital makeover in recent years, and now offer businesses an abundance of streamlined services, tools and access to experts that will help improve your budgeting skills. From regulating current expenses to applying for funding, a well-crafted budget is an essential part of developing a healthy financial forecast for any business.
1. Take advantage of budgeting software
Creating an effective business budget will require a bit more than just utilizing a personal financing software. Luckily, there are plenty of tools available that focus on helping you get your professional finances in order. Centage, which came out in 2001, is a powerful portal that gives companies the chance to streamline their budgeting, while also providing forecasting and consolidation features to help you create more strategic budgeting plans. Investing in a budgeting software is a great way to stay organized at any stage of your professional development.
2. You can’t predict the future, but you can prepare for it
In addition to making the most of the available budgeting tools on the market today, it also pays to do your research. Understanding market fluctuations, as well as competitor activity, will help you create a clear budget plan based on these variables. Keeping up to date on the changes that tend to happen frequently within your industry will also grant your business a bit of extra confidence when it comes to making future decisions. Budgets can provide a strong financial forecast help businesses adapt quickly to changes that might have set them back in the past. For example, if your product is largely dependent on seasonal trends, these projections will give you a greater sense of which months you will be seeing more revenue, allowing you to allocate these funds accordingly throughout the year.
3. Ask an expert
Creating an effective budget for your business goes way beyond simply organizing your finances. Reaching out to an expert to help you construct a budget that fits both your personal and industry needs can better schematize your current plan, and potentially make your business model more profitable.
The rapid growth of the freelance economy has resulted in the creation of platforms that give businesses, big and small, access to a wealth of skilled finance professionals. Whether you’re in the market for a quick consulting session, or on the lookout for a long-term advisor, speaking with someone who specializes in creating budgets for business is a great way to gain valuable insight on the best ways to handle your finances.
4. Don’t forget about funding
Access to funding is an important resource for any business, especially those that are in the early growth stages. Whether you are starting out small with a modest self-investment, asking friends and family for a bit of help, or preparing to pitch a big name investor, having a financial forecast in place is a must.
For those that are hoping to get their hands on VC funding, presenting current activity and future financial projections is an essential part of the process. Of course, investors understand that budgets are subject to change, but without a financial plan in place, investors may question whether or not your business is a worthwhile investment. A clearly constructed budget can help illustrate the value of your company, in addition to showing what will be done with supplementary funding to increase growth.
For small and big businesses alike, an agile and well-crafted budget is key when it comes to maintaining and improving your company finances. From managing the day to day expenses to preparing for unexpected changes in the market, getting into the habit of good budgeting is the best way to ensure steady growth for your company.
It’s Vital To Your Business Success: How To Manage Your Budget Better
Should I take budgeting seriously, and what can it do for me?
A budget is or should be a part of your business plan. It is one of the major control methods to make sure your plan is implemented rather than ignored.
I agree that there are some very successful businesses that operate on a seat-of-the-pants basis, but there are a lot more trying to do so but instead floundering around in the dark.
Unless you are gifted with unerring judgement and great insight you are likely to achieve more success by working to a plan and budget.
Budgets are often prepared by financial managers and tend to focus on operating and capital expenditure rather than sales, purchases, inventory and debtors targets. A better approach is to start by agreeing what performance your company would like to achieve for all key areas.
The sales budget could be a separate section of the main budget to manage expected sales by whatever breakdown suits your business: Type of product, by division, branch or sales channel, or type of customer. In each category budget for margins, discounts and commissions.
Correctly managing your expenses
Key expense items like payroll, overtime, marketing promotions, travel, vehicle expenses and IT costs should be planned for and monitored via the budget but I suggest you don’t clutter the expense budget with too many items which you have little power to manage.
Rather lump these together, you can always drill down if the costs get out of hand. If you have a seasonal business with variations in sales and expenses depending on the time of the year, make individual budgets per month.
Do not forget balance sheet lines, especially capital expenses for new buildings, machinery or vehicles, and also borrowings and other liabilities.
Debtors, creditors and inventory should all be planned and monitored and it is a good idea to monitor measures like average days outstanding for debtors and creditors, days inventory held, bad debts and obsolete or lost stock.
The last items can be target ratios which may not form part of the budget, but should be reported on regularly so that you do not get nasty surprises at the year end. Prepare the budget with everyone concerned to get buy-in. The budget becomes an agreed plan of operations to which everyone is committed.
Continuously review your budget
Monitoring performance against budget should be done at least quarterly, but I prefer once per month in a management meeting. If you are the only manager, set aside time each month for a vital review your performance against budget.
The actual results must be up to date and available. Use a simple spreadsheet showing budget, actual and variance or a dashboard which shows key metrics as graphics or tables.
Examine those items where the variance to budget is significant and probe for reasons. The dangerous ones are the start of a trend — for example sales in one area consistently below budget or mushrooming overtime costs.
For any bad variances that are not just a short-term hiccup you should plan to correct the problem, or if the problem is insurmountable, replan to get around it.
Course correct your budget as you grow
The budget can be changed because circumstances are different to those envisaged when the budget was prepared, but a better option is to add another column for a revised budget, so the amount of the change remains obvious.
Managing the budget should not be limited to complaining about excessive entertainment or travel costs, but a vital tool to give stark visibility to key areas of the business that are not performing as expected.
It should involve all the key players in decision-making to catch and fix problems early, but also to seize opportunities presented by better-than-expected performance at the earliest time.
Treat budgeting as a management tool and it is likely to treat you to more profit and less nasty surprises.
An excellent way to increase profits is to treat budgeting as a management tool. Never be scared of your budget — use it instead.
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