Imagine if you enjoyed a 65% gross margin but still had trouble achieving double-digit net profit margins.
A contracting friend of mine is in this predicament due to his overhead structure and mix of services. He does an excellent job of attracting clients and making sales; he has not scaled his operations to the point where this gross profit falls to the bottom line.
I also see the opposite happen, where a company is making double-digit profits, but their gross margin by divisions are low and could be much higher.
You need to keep an eye on both these metrics in order to drive high-profit growth.
So, why do many companies tend to overly focus on Gross Profit Margin (GPM)?
- It’s easier to compare GPM between companies.
- GPM contains the controllable expenses that your team can impact the most.
- It’s relatively easy to determine GPM by sale and by service line.
Overall, your team will have the easiest time understanding GPM and will be able to positively impact GPM. Therefore, companies understandably tend to over-focus on this metric.
But, it comes with a challenge.
Gross Margins are subjective in nature.
What do I mean by that?
1. GPM are large numbers (percents) that are hard to psychologically pin down. Let’s say your goal is 57% GPM and you hit 52%. In your mind, you are off, but not by a large amount. You missed your goal by just 5 points. In percentages, you are only off by nine percent.
I call this subjective because each manager will interpret this variance differently and many won’t understand the grave nature of that five-point drop.
On the other hand, if you translate GPM into Net Profit, you will find that your profit dropped by five whole points. For example, if you were aiming for 10%, you are now hitting 5% Net Profit.
That is a fifty percent drop in profits. It is easier to grasp the magnitude of this drop. This is a much more objective look at your performance.
2. Also, you may find that sales volume changed from what you originally budgeted. You may in fact hit your GPM goals, but because you miss your sales targets, your Net Profit can still be off by 50%.
For these reasons, I call GPM a subjective measurement and not the final indicator of success.
Therefore, when I work with a new client, I take ample time to look at gross margins and identify opportunities for margin improvement. I ultimately want to see the net profit and I also want the managers to see a net profit by division so we all have an objective view of how each area of the company is performing.
Set up your divisions and division managers with clear net profit goals, by month, with accurate monthly reporting on how their divisions are performing.
The best managers want to do this because they want to know how well they are doing objectively.
One of the challenges in setting this up is determining how to allocate overhead.
I have been through this exercise many times with companies in my community, trying many different methods of overhead allocation. I have found there is no “single right way” to allocate. But in the end, the different methods tend to be close. Thus, you can generally allocate by revenue and then do a double-check using “activity-based” accounting. You won’t be far off.
As an industry expert, I like to look at both the forest and the trees, the big picture and the details. If you take a balanced approach, you will have the best opportunity to maximize company profit and profitable-growth.