In an article a few months ago we explained to you what each of the figures in your profit and loss account means. In this article we are going to focus on the gross profit margin, and more specifically, how to improve this figure.
What is Gross Profit?
The gross profit of a company is calculated by taking it’s turnover (sales) and deducting from this all direct costs of production. These are the costs that a company wouldn’t incur if it didn’t make any sales.
For Example: a company that makes chairs wouldn’t need to buy wood unless they had chair orders from customers. Hence it is not a cost of running the business; it is a cost that is directly attributable to making sales (a direct cost).
What is Gross Profit Margin?
The gross profit margin is simply a percentage that represents how much profit is made from production activities. It is calculated by dividing the gross profit by the company turnover.
Gross profit of £40,000 / Turnover of £90,000 = Gross profit margin of 44%
Ways to improve your gross profit margin :
Calculating your gross profit margin is extremely important for analysing your business and making improvements for the future. You should be using your accounts to make management decisions on how best to run the company. Listen to your figures!
1) Increase staff training
In some businesses certain members of staff are employed specifically to manufacture the products that are being sold. Hence their salary costs are treated as direct costs.
Do you seem to be spending a lot of money on staff and not getting the money back in sales? Maybe your staff are not using their time at peak efficiency? You need to consider the reasons why this is happening. Is it because your staff are not properly trained, and hence can’t work as fast as those who have the proper training?
You should be able to see a direct link between increased staff training and an increased gross profit margin.
2) Invest in production equipment
If your staff are trained correctly and know how to manage their time effectively then maybe you need to shift focus to the equipment they are using. Is broken or outdated equipment slowing down production?
Upgrading or maintaining production equipment could directly impact your gross profit margin.
3) Shop smart for raw materials
The biggest direct cost for the majority of production companies is purchases (i.e. the cost of raw materials). Is your company getting the best price on these raw materials?
There are a few avenues to consider here:
- Are the raw materials at the right level of quality? e. are you buying top end raw materials and then selling the end product for rock bottom prices? You should re-consider the quality based on your target audience and pricing point.
- Is your business one that could benefit from buying raw materials in bulk? Bulk buying is a great way of reducing raw material cost without necessarily having to compromise on quality.
- Making an allegiance with one main supplier of raw materials could benefit your gross profit margin. By building a relationship with the supplier they may extend special offers to you that other companies wouldn’t get.
4) Analyse costs, are they all necessary?
Take a long hard look at all the items listed in your direct costs. Are they all essential costs? Could you make cost savings (and consequently increase your gross profit margin) by cutting certain costs?
Gross Profit Margin Optimisation
It is very important that you don’t read through these suggestions and go on a cost cutting spree. Increasing your gross profit margin is as much about investment as it is about cutting costs. It is very important that you recognise when you reach the optimum gross profit margin percentage for your industry. You will have reached this point when:
- Your staff are well trained and working efficiently.
- Your equipment is operating correctly as and when staff requires it.
- You have cut your costs and shopped around for the best deals without compromising your overall product quality.
You can always set a gross profit margin percentage target by comparing your results to that of a successful company in the same industry (limited company accounts are a matter of public record that can be obtained from Companies House for a small fee).