How margin analysis can improve your business bottom line

Is your business not generating the profitability, and ultimately cash flow, that you think it should? Do you know what your gross margin should be and how to improve it? Here’s what you need to know about margins and profitability.

Understanding Profit Margins

Your profit margin is a measure of profitability that indicates how much of your business’s revenue is retained as profit. There are three main types of profit margins:

1. Gross Profit Margin: The percentage of revenue remaining after deducting the cost of goods sold (COGS). It focuses on just those costs that directly relate to your sales. This includes materials and items purchased for resale including shipping costs; wages and salaries for staff directly involved in delivering the service or selling the product; inventory holding costs and travel expenses of service staff.

• Formula: Gross Profit (Revenue - COGS) / Revenue
  

2. Operating Profit Margin: The percentage of revenue remaining after further deducting operating expenses such as wages, rent, and utilities. Include here all the other costs involved in running the business.

• Formula: Operating Income (Gross Profit – Operating Expenses) / Revenue

3. Net Profit Margin: The percentage of revenue remaining after all expenses, including taxes and interest, have been deducted. It represents the overall profitability of the business.

• Formula: Net Income (Operating Income – Taxes & Interest) / Revenue

Is my gross margin the same as my markup?

The terms "gross margin" and "markup" are often used in business finance and can sometimes be confusing. They both relate to the pricing and profitability of products, but they are calculated differently and serve different purposes.

Gross Margin

As mentioned above, this is the percentage of revenue remaining after deducting the cost of goods sold (COGS).

Example:

- Revenue from selling a product: $200

- COGS: $120

- Gross Margin Calculation:

In this example, the gross margin is 40%, meaning that 40% of the revenue is retained as profit before accounting for other expenses.

Markup

Markup is the amount added to the cost price of goods to cover overhead and profit. It is expressed as a percentage of the cost price.

Markup helps businesses determine the selling price of their products to ensure they cover costs and achieve a desired profit margin.

Example:

- Cost Price of a product: $120

- Desired Selling Price: $200

- Markup Calculation:

In this example, the markup is approximately 66.67%, meaning the selling price is 66.67% higher than the cost price.

The above calculations illustrate that adding a 66.67% markup to a cost of $120 will generate $200 in revenue and $80 in gross profit. However, this $80 only represents a 40% gross profit margin on $200 of revenue.

Analysing Profit Margins

Benchmarking

Internal Benchmarking: Compare current margins against historical data to identify trends and set realistic targets. Is your gross margin improving or deteriorating compared to prior periods? In our current inflationary environment, are your costs spiralling faster than you can recover from price increases?

External Benchmarking: Whilst it is unlikely that you can access the financial results of competitors, there are useful industry benchmarks provided by the ATO, see link (ATO Industry Benchmarks). These can be useful in comparing your business against a broader sector analysis.

Break-Even Analysis

This analysis determines the sales volume at which total revenues equal total costs, meaning no profit or loss and helps in setting sales targets and pricing strategies. For example, a small café might calculate that it needs to sell 300 cups of coffee per day to cover all costs and start making a profit.

Segment Analysis

Analyse margins for different product lines, services, or customer segments to identify which areas are most profitable. This may lead to focusing on one product or service line over another, or the realisation that prices need to change for certain items. For example, an e-commerce business might find that while electronics have high sales volumes, their gross margin is lower compared to niche handmade crafts which have fewer sales but higher margins. For all the effort and resources focused on the electronics lines, they may well produce less total gross profit than the lower-selling handmade crafts.

Cost Structure Analysis

It is important to understand which costs are fixed and which are variable costs in your business so that you can accurately set markups to generate a required gross profit margin.

A manufacturing business that forecasts to sell 1,000 items in a year will need to know the variable cost of production per item, and then allocate a proportion of the business fixed costs to each item to break even.

A trades business will need to calculate the estimated number of chargeable hours that a service staff member works (allowing for leave, down time) when calculating charge out rates to cover labour costs plus fixed overheads.  

How an outsourced CFO can help

You are right in thinking that this is complex stuff, and few business owners have the time or the financial skills to tackle this kind of detailed profit margin analysis. These tasks should be outsourced to an expert accountant if you do not have such a role internally. An outsourced CFO is the perfect solution.

CFO is short for Chief Financial Officer, and this is the most senior and experienced finance professional in most big businesses. A CFO provides high quality finance, accounting, commercial and operational advice to a business. Not surprisingly, a CFO comes with a hefty salary and cost to the business, and so it is usually only larger businesses that hire a full-time CFO.

Smaller businesses, particularly those that are looking to grow and expand services, also need the advice and services provided by a CFO but not on a full-time basis. This is where an outsourced option comes into play. An outsourced CFO could work on a one-off project or on a retainer, for a much smaller number of hours per month. This means the cost is substantially lower than hiring a full-time resource.

An outsourced CFO would be able to analyse your company profit margins and work with the business owner on strategies to improve margins and profitability, such as:

• Increasing prices - Carefully raising prices can improve margins without significantly reducing sales if managed correctly. Communicating the value and reasons for the price increase to customers is key to maintaining loyalty.

• Changing the sales mix - Focus on selling higher-margin products or services. Upsell and cross-sell to increase the average transaction value.

• Improving operational efficiency - Streamline operations to reduce waste and lower costs. Invest in technology and training to enhance productivity.

• Negotiating better terms with suppliers – Does it make sense to make bulk purchases to obtain discounts or take advantage of early payment discounts?

• Controlling overhead costs – Outsource non-core functions to reduce payroll costs; review all subscriptions and IT software to ensure they are still being used; seek alternatives when annual costs are due to renew.

• Improving inventory management - Optimize inventory levels to avoid overstocking or stockouts. Use just-in-time inventory systems to reduce holding costs.
  

Why should I choose GearChange Business Advisory?

At GearChange Business Advisory, our passion is supporting business owners to turn their dreams and goals into an actionable business plan that gives you the best chance of success, and the future you deserve for you and your family.

Our business is led by Steven Nicholson who has over 30 years of experience helping small and growing businesses achieve their business goals by advising and supporting business owners with commercial advice and insightful financial information.

Steven’s extensive experience has taught him two key things that ensure a successful outsourced CFO engagement:

1.      All businesses are different. Rather than a one-size-fits-all solution, Steven will always tailor the services to meet the specific requirements of each client, ensuring that their financial strategies align with their business objectives.

2.      Build a trusting relationship with the business owner. Steven’s relaxed and honest communication style allows him to lower barriers quickly and show the value he can add as a trusted business advisor. This is critical to understanding the true worries and drivers of a business owner and ensuring that these are front of mind in any solutions provided.

What should I do next?

By outsourcing profit margin analysis to an expert in the field, you can focus on what you do best – running and growing your business.

Get in touch with GearChange Business Advisory for a no obligation chat to see if we can help your business move up through the gears.

Initial free CFO consultation