Every business owner should understand the industry they are in and the benchmarks such industry brings. There are so many factors affecting Gross Profit margins and it is one of the critical success factor areas that deserves a lot of attention!
Every business has a model that has been developed over the years and evolved as times changed. This model is a very good indicator of what the market find acceptable and further indicates how the business should be structured from a cost point of view to ultimately result in profit that gives return to shareholders and also can be reinvested in growth.
What are we talking about?
To prove to you how important the GP margin in a company is, I am going to focus on a typical consulting business for the purposes of demonstration. What are the costs to understand in a business like this?
Variable cost and fixed cost. What would qualify as the variable cost for a consulting type business?
Salaries? Is this not fixed cost? Yes in most instances it is, but without this cost the revenue would not be possible. Even though this cost is fairly fixed, we do recognize this cost as a variable cost, mainly because this bill normally directly grows as the revenue grows.
Travel cost, disbursements, accommodation specific to jobs, performance incentives are all part of the variable costs, or else known as the cost of sales, of a consulting business.
What would qualify as the fixed cost of the business?
These costs typical are the costs that remain constant even when revenue decreases or increases. Typical examples are rent, cleaning, utilities, telephones, internet line etc.
So how important is that GP margin??
If we had to cover fixed cost employed in the business then the GP margin is the most important margin to watch because if you get that right then the business makes sense.
Your typical ratio in a consulting business is as follows:
Cost of sales: 50
Net profit: 20
If the GP margin falls below the 50%, then the pressure is on the business to produce more sales at a lesser price in order to cover the overhead. It could also be a case of producing sales at the correct price but with too much cost of sales. In other words the break even point has moved and more sales are required from the same people to cover the overhead cost. The flip side to the coin is too little sales from too many people. This refers to productivity issues.
Pushing the GP margin beyond 50% then less work is required from the same people at a better rate and excess capacity will allow the business to generate more profit. This is without a doubt the optimal position to be in.
How do we get the GP up if the market dictates the model?
In tough economic times the only way to do this would be the combination of price and excellent service. Even though times are tough, excellent results driven service is critical and revenue can be achieved at the correct margins.
Watch your GP margin in your business, irrespective of the industry you are in, and your business will succeed!
Contact us today for a free assessment and obligation free quote and we will help you identify your desired margins and help you improve on them!