There is one important number in your business that will substantially increase your profits and cash flow. Do you think it sounds too good to be true? I assure you it isn’t. Most people concentrate on getting more sales, more revenue, more income, forever searching for more clients or customers. Whilst I’m not denying that increasing sales is important, there’s another number that is key to success.
Let me explain by providing you with a few numbers to consider.
Sales revenue $ 50,000
Less cost of sales $ 20,000
Gross Profit $ 30,000
*cost of sales is purchases and freight for a product based business, or employment costs and contractor costs related to delivery of services in a service based business.
The Gross Margin is 60% (gross profit of $ 30,000 divided by sales revenue of $50,000 expressed as a percentage).
Now consider the following three alternatives:
Alternative 1 Alternative 2 Alternative 3
Sales revenue $ 50,000 $ 60,000 $ 60,000
Less cost of sales $ 16,000 $ 30,000 $ 24,000
Gross Profit $ 34,000 $ 30,000 $ 36,000
Have a good look at each of these and consider which would be a better result than the original current status figures. Pick one and then let’s look at each of them in detail.
Alternative 1. In this example the sales revenue has not increased so you haven’t got any extra work to do. What has happened though is you’ve found ways to be more efficient in your service delivery or got better pricing on your products. Recent research of business sentiment in my local government area cited getting sales as the number one challenge facing businesses. How good would it be then to know that you could make more profit without selling more?
Alternative 2. If you’re just focusing on sales revenue, these figures look great at first glance. You’ve increased sales by $ 10,000, or 20%. Great job you think. But actually no as you’ve also increased your cost of sales significantly and horror of horrors you Gross Profit is exactly the same as in the current status figures. So although you’ve increased your revenue you’ve worked harder, sold more but not made a single dollar more than you had before. Why would you bother?
Alternative 3. Again like the previous numbers, you’ve increased sales revenue. Bravo, well done. But in this example, you’ve also kept control of your cost of sales and the result is a significant increase in the Gross Profit from the current status example. Good job.
Now let’s look at the Gross Margin for each of these alternatives:
Current Status – Gross Margin is 60%
Alternative 1 – Gross Margin is 68%
Alternative 2 – Gross Margin is 50%
Alternative 3 – Gross Margin is 60%
Now consider which of these you’d prefer to have. I’d go for Alternative 1, at 68% it is much better than the current status of 60%.
Let’s take it one step further and look at what would happen if you were able to combine increased sales revenue with an increase in the Gross Margin:
Sales $ 60,000
Less cost of sales $ 19,200
Gross Profit $ 40,800
Gross Margin 68%
By increasing revenue by 20%, increasing Gross Margin from 60% to 68%, you’ve now increased your Gross Profit by $ 10,800 which is an increase of 36% ($40,800 – $ 30,000 divided by $ 30,000).
The one number you need to be focusing on in your business is your Gross Margin. Work on finding ways to increase it. Don’t even worry about looking for more sales revenue until you’ve increased your Gross Margin as much as you can. There’s no right or wrong Gross Margin although there are generic benchmarks available in most industries. Rather identify what your current Gross Margin is now and then work on tweaking your costs and efficiencies until you can’t tweak them anymore. Then and only then should you switch your focus to looking for more sales revenue.