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The Mathematics of Gross Profit
By
James Grandillo,
Senior Retail Consultant
I have often been asked: How do I establish
what the correct Gross Profit Margin Percentage for my company should be?
That’s one heck of a question. It is
very complicated, but I will try to walk you through it.
Step One (A): Determine total yearly
expenses. This includes rent, salaries, administrative costs,
advertising, fuel usage, depreciation of fixed assets, warehouse
supplies – EVERYTHING. You should have last year’s taxes or possibly
even a financial statement to guide you here. Given the present
state of the economy and your business, ask yourself - will you spend
more or less than last year, etc.
Step Two (B): Estimate yearly sales.
Use last year’s actual results as this year’s benchmark. Forecast an
increase if you are an optimist, a decrease if you are a realist or a
pessimist.
Step Three (C): Decide on how much Net
Profit Before Taxes (in dollars) you would like to earn for all your
efforts. If you are paying yourself modestly (dealt with under
Expenses above) then 10% of your sales is a nice easy round number to
use (but 5-7% may be more realistic: you decide – you ARE the boss,
after all.)
Step Four (D): Use this formula:
A+C
B
This equals
the optimum percentage for your company, given the assumptions made in A, B,
and C.
If you play with this equation, you will see that often your results will
show you require a larger Gross Margin Percentage than is customary in your
industry. For instance, use these numbers:
A = $1,000,000 Expenses
B = $2,000,000 Sales
C = $100,000 Profits (equaling 5% of sales)
Plugging the numbers into the equation we see that, to accomplish our profit goal we
need a 55% gross profit percentage, or a Cost of Goods (landed) of only $900,000. A
GP% of 55% may be unrealistic for, say, a furniture store. Where have we gone wrong?
Let’s re-boot. Let’s
say we can trim our expenses by $100,000 (we’ll worry about how later…). Let’s also
reduce our profit expectation to 3%, and increase our sales to $2,200,000. Now we have:
A = $900,000
B = $2,200,000
C = $60,000
This gives us a GP% of 43.6%. In home furnishings, this is not only doable but might even be considered a little on the low side.
If you fool around with this simple equation you will see that you can
massage the GP% in either direction. However, what you are confronted with is this: How
will you reduce expenses and increase sales? Is there some magical way of doing this?
Of course, there isn’t.
The art of managing is the art of
influencing people and outcomes. If you need to increase sales there are a host of strategies you can engage in; so many that discussing them now is beyond the scope of this article. Likewise, if you have to reduce expenses there are many things you can do – also beyond the scope of this article. But right now let it suffice for me to make this mysterious statement: It is management’s responsibility to
improve the productivity of every employee, for in that improvement lies the profit that is required to justify the risk and capital outlay that your entrepreneurial venture demands. If management cannot successfully
improve productivity, their retail experiment will fail.
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