“Metrics that Matter” is a four-part series designed to deliver a pathway and a practice to the most impassioned small business owners. The ones that built their companies not because they had a background in business but a passion for delivering the kinds of products and services they clearly saw a need for delivered at a service level that was missing from the marketplace. This series is designed to empower and elevate you and your team so that you can win the game.
If there was a World Series for metrics, the gross profit margin would be the odds-on favorite to do a series sweep and get it done in four games. That’s because the gross profit margin can tell you which moves you can make to have your whole business avoid any unforced errors and hit a grand slam home run to clinch the series. How can one number be so powerful?
The gross profit margin (GPM for short) isn’t just a number—it’s an indicator of how your business is operating currently, and a predictor of how your business will perform in the future. Once you master this metric, you will be able to understand the options that your business has in making the most suitable corrections or taking the right course for growth.
Many small business owners have followed a path that led them from a passionate vocation to a professional pursuit. The similarities are striking—it starts with an energetic interest that grows into a mastery of the domain. Maybe you love cooking and food so you now have a restaurant, you took your love of bike riding and transitioned that love into a career by owning a bike shop or a bike touring company. Intense attention to a particular way of seeing that passionate interest took you on a journey from novice to expert. It makes you an amazing resource for your clients and customers. You are their “go-to” for anything that they need in that arena. That’s because you are highly competent and credible at what you do. This translates into customer reviews that say things like “completely awesome” and “they know their stuff inside and out.”
WIIFM (what’s in it for me?)
Being completely awesome in the domain of your vocation is the best place to start growing your business but it’s not the whole story. Here’s the part where I’m going to start talking about the numbers with you. A fair percentage of you have just frowned. Stay with me here. I will get nerdy. You might be thinking “WIIFM (what’s in it for me) if I stay and read through this. Well, it could mean that next level breakthrough of understanding that will help you direct your business in a way that bring you relief from the torment of not knowing how to make the right decision about your business. Not understanding the numbers and what they’re telling you is the secret anguish of the small business owner. It’s the embarrassment of not knowing how to lead your team so that you can afford to give better benefits or give your best people that raise you know they deserve. It’s being able to feel comfortable taking your family on a vacation and knowing that your business can make payroll while you’re gone. You keep telling yourself that sometime, sometime soon you’ll do better, save some money or sell more so that you can make the leap to being more profitable. But that sometime soon never comes, not with how you’re doing things now.
What I know is that having facility with the GPM helps you lead your people better, make better decisions and sleep soundly at night. Those are the benefits of understanding your GPM and managing from it appropriately. Interested now? Ok, let’s get started in making you a better leader, a better owner and a better financial manager.
What actually is my Gross Profit Margin (GPM) anyway?
Your GPM is a product of two things: your income (that’s often times all the sales that you make) and the cost of making your products (your direct labor and raw materials) called your “cost of goods sold” (COGS for short). Sometimes you’ll see this as Cost of Services in service-oriented companies but for our purposes we’re going to use COGS.
What counts as income?
For clarification– Income for most small businesses is the amount of money the company makes from sales. It can also include the money you take in for subletting some space to another company or any investments the company has made. For most businesses, any money that comes in the door is categorized as income.
COGS is categorized as direct labor and raw materials that go into a product. For clarification purposes that means any personnel who are working to make the product. That means if you are a cabinetry company, the engineer making the drawings, the fabricators who are building the product, the finishers who are finishing the product, the quality control inspectors who are ensuring that the product is well-built as intended and complete are all included in the COGS calculations. The data entry person who is managing the payroll inputs is classified as an expense, not as part of the COGS calculation. Why? Because this person, although laboring to do a good job for you, isn’t necessary to make the product that you are selling. Their efforts are classified as an expense that the business incurs as part of “the cost of doing business.” We will talk about the difference between COGS and expenses later.
What counts as materials?
Materials are all of the components that go into making the products your company sells. If you are making cabinets, you’ll need to buy wood, nails, hinges and drawer pulls, finishing materials like paint or lacquer (water-based hopefully because it is more environmentally sound), all of the components that a company needs to make their product goes into the COGS bucket. The hallmark of raw materials is that a company takes one material and improves it somehow by adding other components or creating new value (like a product) out of a raw material. Just like a cabinetmaker does when they take wood panels and make them into cabinets.
What about shipping the product from the cabinet shop to the customer? Isn’t that part of COGS? No, shipping costs of getting the product to the store or to the business or individual who ordered the product is thought of as an expense, not part of COGS. This is an important distinction and one of the key conversations about looking at the business expenses again lumped in with “the cost of doing business” that an owner often hears.
Why did we just get into the nitty gritty here with COGS? So many people take it for granted that the COGS is a dump bucket in your income statement for all kinds of expenses like shipping or marketing items but it really isn’t. There is a lot of misinformation that small business owners have taken on that just isn’t correct and just doesn’t serve them. In this case, the COGS oftentimes is one of these misunderstood categories in the income statement. Here’s where you get great benefit from understanding why it is a disservice to the small business owner to not understand what large companies do. Large companies put a lot of resources to work to maximize the value of their own information gathering and data. Why do large companies spend time, money and effort to reviewing their own data? Because it is key to asking and answering the right questions and then taking the appropriate action. This is where financial data moves from a two-dimensional conversation to a three-dimensional one.
Your GPM Is a report on your management and purchasing skills
Let’s go back to your COGS. Remember that the two elements of your COGS number are direct labor and raw materials. In a perfect world, these numbers should be stable. It means that you’ve estimated correctly the amount of labor it takes to make your product and the amount of raw materials (including waste) that it takes to make your product. That’s in a perfect world. In reality, we have all sorts of variables that impact how much labor it takes to produce a product and how much raw materials are in use or how much they cost to make your product.
The GPM should be stable from month to month in your reporting. If it is not, it leads a business owner to the process of asking and answering questions. Questions like:
- My materials costs rose this month. Why?
- Our labor costs include a lot of overtime. What happened?
- Is this a permanent condition or is this just something out of the ordinary that will only happen once?
This sends you and your team to delve into these questions and find out answers. You could find out that your materials costs went up because the price of raw materials rose. You can find out if this is a temporary condition or a semi-permanent condition. It might be that there was a shortage on wood because one of the processing plants had a fire and couldn’t produce the wood panels that you need to make the cabinets. It could be that there is a 25% tariff placed on raw materials coming from another country and that you will have to pay more for the foreseeable future.
Once you find out the underlying reason for the increase in the materials costs, you have a decision to make: do I raise prices to pass along these increased costs to the customer or do I absorb these costs?
Delving into increases in your labor costs is a more managerial Q&A for you and your team. If your labor costs are increasing, you would want to find out if it is taking your people more time to produce the products. Some of the questions you would want to ask include:
- Is all of the equipment they need working properly? If it isn’t why hasn’t it been fixed? When will it be fixed?
- Are all of our people trained properly? If there are new people making the product, what will it take to get them up to speed?
- Did the company get a big rush order? If so, was a rush charge added to the order to cover the increased expenses for the rush order?
Knowing the reasons behind the cost increase gives you power to make the right decision for your company. Once you find out the root cause of these issues, then there are decisions for you to make. Here’s all the right moves:
If your materials costs are climbing and there is a lack of predictability around these increases, you must raise your prices. Passing along the kinds of costs that continue to nibble away at your margin will help you reduce one side of the COGS equation.
All COGS labor cost increases mean that you have to make management decisions around your labor practices. Knowing why overtime is required will help you decide the right course of action. Some actions around labor costs include:
- training your people better
- mixing up experienced and less experienced labor to help train your new people while reducing the cost of errors and slowed production that occurs while people are learning
- hiring more people because the workload is too heavy for the current staffing level
- moving to a second shift production might help with managing overtime
Here’s the powerful lever that the GPM gives you—the lever of decision-making through management practices. Anything that effects the COGS means that management takes action to improve its internal practices—purchasing practices and production labor practices. When we see a swing in the GPM, small business owners know that they have to look internally as to what exactly is happening in these two areas.
How GPM effects “below the line” expenses
Most of the expenses below the GPM have an open secret–you can negotiate to lower costs most easily with variable expenses. With most variable expenses whether it be an email marketing or an insurance company, you can negotiate the price of their services for your business. If you can’t get the lower costs that you’d like, you can always find another vendor who can operate at a lower price (remember, they may not give you the best service but it will be at a lower price if that’s your primary objective). If cutting expenses is the strategy you want to use to increase your bottom line, negotiating variable costs is often the quickest way to doing this.
Integrity in the numbers
Making certain that your data entry in your financial record keeping system (like Quickbooks or other) is an essential activity in your business. Oftentimes new or unskilled business owners think they’ll be saving money if they do their books themselves. This couldn’t be further from the truth. If you haven’t taken an accounting course or a small business finance course that teaches the elements of bookkeeping, do yourself the best favor ever and hire a bookkeeping firm. Some of the worst mistakes I have seen in business are the ones that novice owners have made with bookkeeping errors. You’ve heard the saying “garbage in garbage out” well, this is a prime example. If your bookkeeping and record keeping isn’t reliable, it doesn’t do you any good to try to use your numbers for guidance and decision-making. If you are committed to doing the data entry and numbers yourself, do yourself a favor and take a quick class to learn the rules of the road. It will pay off exponentially for you. You will be able to generate reliable financial reports and this is the basis to running a good business and being able to trust your data so that you can grow into the powerhouse you know that your business can be.
Making your GPM your MVP
Taking what you learned here and turning it into a company practice will cement the habit of using your hard-earned data for decision-making. First thing that must be done: properly collect your data. Collecting your employees digital or physical timecards and inputting this data into your accounting system is key. Of course, there are many digital companies that have apps to help facilitate this. The most important part of this is that it gets done. The best app is meaningless if your staff doesn’t follow the guidelines for data collection. It’s imperative that your staff participate and understand how important it is for them to give correct data so that reliable reports can be generated.
It is also very important that you track materials costs and stay in touch with your most important or key vendors. Oftentimes, they will share with you when a price increase is coming so you can anticipate it or find a substitute for the material that is affected by a price increase. Knowing what the cost of your components are from month to month will help you manage your margins.
Every month, your company must close your books. This means reconciling your outstanding accounts like bank accounts (payroll accounts, operating accounts, credit cards etc….) and running your income statement reports—try for the same day of every month and put it on your calendar. Turning an idea into a practice is the way to take what we know we aspire to into something we know we can accomplish.
Your income statement is your most accessible tool that shows you your trending results from month to month, quarter to quarter, and year to year. Your GPM is the guiding light that gives you the information to ask and answer the questions that help you captain your company to playing the game with confidence and easy. Having the tools, the people and the practices come together makes your company hum. Who knows, with mastering your GPM, maybe you can be the winner takes all in your industry’s world series.