A big mistake that steals profits in your SME
Take a closer look at your Profit and Loss Report
It may well reveal easy ways to uncover more profit in your SME.
Understanding your markup and margins then setting your prices well are as critical as the number of sales you make when it comes to boosting your SME’s profits.
Your profit and loss report is like a story that tells you:
Between this date and that date,
these are the deals transacted in your business and
that resulted in a profit or a loss.
And just like any story there are Characters (your Revenues and Expenses) and Chapters (your Subtotals and Totals). Most SME owners keep close watch on their Revenue Characters, making sure the sales, rental incomes and royalty payments are all carefully billed and received. The villains, who are often left to their own devices, are the expenses.
Back to a big mistake that steals profits
If you have a service business then luckily you are unlikely to be making this mistake, because you don’t have any direct expenses. For everyone else:
having a fantastic Gross Profits Per Item alone does not tell the whole story of how well your business is running;
the number of sales is also critical to your businesses overall the Gross Profit on your Profit and Loss Report, and ultimately what you get to take home. If no-one wants your product, because it isn’t in demand or your price is too high, then you won’t generate much revenue and the Gross Profit for your business as a whole will be low. Thinking that by setting your prices really high, and having a great Gross Profit per Item, may lead to you stealing your own profits by reducing the number of sales you make and therefore how much you get to take home. If that seems confusing, it is – which is why so many mistakes are made!
How to address this mistake and uncover more profit in your SME
First, understand a few basics
Just like the Red Sox and the Dodgers, your expenses tend to be grouped into two teams Direct Expenses and Indirect Expenses (sorry – I tried to think of famous families in literature to use instead of teams in this example, but they were boring!)
The term ‘direct’ here describes a linked relationship between these outgoings and the sales revenue. So, if sales increase, direct expenses will also increase by a relative proportion. This may not be an exact 1:1 ratio (i.e. one more unit sold = one more unit of expense), but there is always a correlation between the sale and the cost.
Direct Expenses usually only appear on Profit & Loss Reports of manufacturers or retailers supplying stock, and are expenses such as raw materials, inventory, etc. Service businesses generally do not allocate any costs to Direct Expenses, as they cannot, for example, hold, or sell, their staff as ‘stock’.
The term ‘indirect’ means there is no linked relationship between sales and these expenses – and these expenses happen irrespective of sales being made. i.e. think of it as all the bills you still wrack-up even if you have a bad sales month or as all the expenses needed to get your roof “overhead” before you can make sales.
While the teams by themselves are interesting, the story that results from their interactions is where you can uncover more profit in your SME.
Next, Gross Profit
One of the most confusing sub-totals on your Profit and Loss Report
Also sometimes known as Gross Revenue, Gross Profit Margin or Gross Margin when expressed as a percentage.
This sub-total adds together Revenues, and then subtracts the Direct Expenses related to those revenues. Remember Direct Expenses are those where the amount of the expense is related to the amount of sales, so increases in revenue create increases in direct expenses. This sub-total is won’t show up if you have the kind of business that is a service provider with no items or products forming part of your sales, because if that is the case you wont have recorded any direct expenses. Just to be confusing the name Gross Profit is used in many different ways:
- Gross Profit can be looked at for the business as a whole in which case the calculation is:
(Sales Revenue – Direct Expenses) = Gross Profit
- Gross Profit also can be calculated for individual products (items):
(Item Price – Item Production Expenses) = Gross Profit per Item
- and for product lines:
(Item Price – Item Production Expenses) x number of items Sold = Gross Profit per Product Line
- AND finally (while I am being “maths-ey”) – Gross Profit Percent (also called Gross Margin or Gross Margin Percentage). To calculate your Gross Profit as a percentage can be done for the business as a whole, items or product lines – it is REALLY EASY:
Gross Profit / Revenue = Gross Margin Percentage
So watch out what the Gross Profit number relates to – if it is on your Profit and Loss Report it will be an amount relating to monthly sales, but in other reports it could relate to single items, or whole product lines, so it is worth checking exactly what you are looking at before you jump to a wrong conclusion.
That covers off all the versions of Gross Profit – it is very very useful, because it highlights how much profit is generated from processing inputs, buying stock, and preparing items ready to sell, before considering the sales processes or including the overheads and administration. This outcome must be sufficient to cover all your overheads to ensure you are able to stay in business AND preferably also leave some extra.[/twocol_one_last]
Before you give up because you are feeling quite lost, this example puts it another way. Consider two bike manufacturers – each will have as their direct expenses the bicycle components; frames, wheels, gears, brakes, seats, etc. consider two bike manufacturers – each will have as their direct expenses the bicycle components; frames, wheels, gears, brakes, seats, etc
Reid’s sell their bikes for $2,400 and McBikey for $500 which means:
– Reid’s Bikes gross profit per bike is $2,400-$2,000 = $400
– McBikey’s Bikes gross profit per bike is $500 – $300 = $200
Therefore Reid’s have a Gross Profit per bike that is almost double that of McBikey’s – which on the face of it would seem to be a fabulous thing. However, in an average month McBikey will sell 18 bikes but Reid’s will only sell 3 Bikes – so their actual Gross Profit per month will be:
– Reid’s Bikes $400 x 3 = $1,200 gross profit per month
– McBikey’s Bikes $200 x 18 = $3,600 gross profit per month
Or we could also calculate this as:
– Reid’s Bikes ($2,400 – $2,000) x 3 = $1,200 gross profit per month
– McBikey’s Bikes ($500 – $300) x 18 = $3,600 gross profit per month
Last, What does this mean for you right now?
To find out how to uncover more profit in your SME start by calculating your Gross Margin percentage and comparing it to other similar businesses. Remember from above, this is done by looking at Last periods Profit and Loss Report (it might also be called your Income Statement) and then doing this calculation:
Gross Profit / Revenue = Gross Margin Percentage
Most industries have a fairly standard Gross Margin Percentage. Find out what yours is by checking with your industry association, then compare it to your own (you can use the web or give them a quick call)
- If yours is higher: Be sure to treat your customers well, and continue to deliver the value they perceive.
- If yours is lower: Examine your expenses and understand if production is costing you more than others in similar businesses. Investigate increasing your prices OR be happy with your lower margin, but get busy and sell a lot more than everyone else!
Understanding your markup and margins then setting your prices well, is as critical as the number of sales you make when it comes to boosting your SME’s profits. From our example if Reid’s Bicycles had realised how different their Gross Margin was from their competitors they could have adjusted their business model to ensure they remained competitive, rather than going out of business.
Do you understand the whole story of your Gross Profit?
Now that you have a taste of what we can do… here are some more options to improve your business profits: