Finance & Operations Tactics
Business owners don’t need to be CPAs to keep their companies in the black, but they do need to know some basics. Among these is knowing how to calculate their gross profit margin or, in other words, the amount of money left over after accounting for the cost of goods sold (COGS).
“Business [owners] have about the same grasp on their profits as they do on the gas mileage of their car — they have a rough idea, but nothing exact,” says Emily Chase Smith, a business financial coach out of California. Before becoming a financial coach, Chase Smith spent several years as a bankruptcy attorney for small businesses. “They have a few rough numbers and probably an idea of how much cash is in the bank, but they either don’t track the money carefully or don’t look at the reports that do.”
There’s a lot more to keep track of with business finances than personal finances, and many business owners only have experience managing their own personal finances. One of the first things a business owner needs to know is whether they are turning a profit.
Chase Smith breaks down how to calculate your gross profit margin.
Step 1: Add up all the revenue you had over the time period you’re working with — a day, week, month, quarter or year. This is your gross income.
Step 2: Then add up everything it took the business to get the sale (advertising and marketing), make the product (manufacturing, labor), and get it to the customer (shipping and handling—either from the manufacturer to the store or through the mail). These are your cost of goods sold (COGS) — direct expenses related to producing a good or service.
Step 3: Subtract the COGS from your gross income. This is your gross profit.
Step 4: Divide your gross profit by gross income and that’s your gross profit margin.
If your gross profit margin is negative, you need to make some adjustments. Are you charging enough for your product? Can you lower costs somewhere else, such as focusing on reducing manufacturing costs, to increase your gross profit margin?
Chase Smith suggests asking vendors for bulk discounts where you know you can move the product. Or take a look at the potential benefit of discounted payments from your customers where available. For example, if you sell in bulk you may have to wait 60 to 90 days for payment, but may receive faster payment if you take a lower amount.
“A small business should calculate its gross profit margin every time an element of the equation changes, even if it’s just by a small amount. It’s as if you were a commuter and the price of gas went up. That change — a few cents more per gallon — will affect your entire budget,” Chase Smith explains.
The key is to watch your business’ finances over time. “You want to know what direction they’re going in and how quickly,” says Chase Smith. “You can compare any time frame — over the course of a year or this October versus last October. Keep a close eye on the numbers and their movement, and that will help you catch little problems or changes before they cause too much damage to fix.”