Business Financial Metrics – #6

Posted: February 12, 2013 in Business Financial Statements, Up-and-running Business

I probably should have ranked this metric higher than #6 but I will give it appropriate mention here. The metric is: gross profit margin or simply gross margin (GM).

Gross margin is the percentage quotient when you divide gross profit into revenue. The direct cost of sales includes direct material and direct labour costs. The gross margin tells management how economically, efficiently and effectively the business delivers a product or service.

If a business generated a gross margin of 55% in 2011 on revenue of $2.1 million the gross profit would be $1.16 million. The $1.16 million would have to cover marketing and promotion as well as general and administration expenses.

If the business grew revenue to $3.0 million in 2012 but the gross profit margin declined to 51% the results would be telling. The gross profit would be $1.53 million. This represents a 32% increase from the gross profit the year before – in dollar terms. However, growth in sales usually results in growth in general and administration overheads. The bottom line (net profit) might be very disappointing for management – in fact even shocking.

Another way of looking at this comparative metric is by using the opportunity cost/benefit principle. If the business had retained the gross margin of 55% in 2012 (not the 51% it actually attained) the gross profit would have been $1.65 million. The “delta” would have represented $120,000 more in profit than it achieved.

The question management needs to answer is “why?” Why was there such a decline? Was it competitive pricing or no attention paid to inputs? This could spell disaster for the business. If sales flatten (ie. cease to grow) with slim margins the income could be squeezed and the cash flow squeezed as well.

The gross margin in an important metric that business owners need to understand.


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