I recently met with a client in the specialty food business. The company, in short time, gained product placement throughout the southeast in one of the largest grocers in the United States. However, her company is operating at a loss, and to make matters worse, her cash balance is dropping faster than her operating losses. Not sure why this is happening, she sought assistance from the SBDC.
During an exploratory meeting, I asked what it costs to make her products so I could get a sense of gross profit margins. She did not know nor did she have any idea of gross profit margin. She was operating by the basic principle of buy low, sell high. The only two numbers she was clear on were sales and cash. Beyond that, the numbers on her financial statements were a mystery. In the big picture, this is not a winning formula. The business owner in today’s competitive economy does not need to be an accountant or a mathematician to be successful. However, the owner needs to possess an essential level of financial intelligence to manage a business. If a pilot was told that the only gauges working on the plane were fuel and speed, there is no way he or she would attempt a flight. Those two measures alone won’t be enough to fly a plane nor will just checking sales and cash be enough to run a business.
One of the most important numbers an entrepreneur needs to know is gross profit margin. Sales minus of cost of goods or services equals gross profit. Gross profit when reflected as a percent of sales is gross profit margin. So if a company has monthly sales of $100,000 and a gross profit of $70,000, it is working on a 70 percent gross profit margin. In other words, the company makes 70 cents on every dollar sold before paying for operating costs. Many retailers aim to work on a 50 percent gross profit margin. If a widget costs $1, then they price it at $2. This yields a $1 gross profit on a $2 sale, or 50 percent gross profit margin. Understanding this can quickly reveal the feasibility of the business. For example, if an entrepreneur works on a 40 percent gross profit margin and expects annual sales of $500,000, then he will have $200,000 available to cover operating costs. Since his operating costs are $150,000, the business is feasible.
Let’s consider another client who owns a home improvement business and is planning to work on a 40 percent gross profit margin. When jobs estimates are figured, he adds up the material and labor costs and multiplies the total by 1.67 to yield a 40 percent gross profit margin. So far, so good. Where he falls short is monitoring prices and costs once the jobs begin. At the end of the year, his accountant informs him he lost money and that his gross profit margin was 25 percent. One or two things occurred: either there were costs incurred and not passed through to the customer or there was price discounting by the sales staff that he was not aware of. The big problem here is that he is not monitoring his gross profit margin on a timely basis. When a job is completed, there needs to be a profitability report. If he chooses to leave the barn door open until his accountant does the year-end tax return, then he does so at his own peril.
In business there are lots of numbers to pay attention to. Some come with dollar signs and others without, and it’s usually the ones without that are the most important to driving a successful business. For example, Domino’s Pizza has built a giant business based on delivering pizza in 30 minutes or less. There is no dollar sign in front of 30 but this is certainly one of the company’s most important numbers.
An easy way to organize and monitor performance, both financial and nonfinancial, is to use scorecards. A scorecard can be nothing more than data collected and organized on a legal pad or a powerful Excel worksheet such as the financial scorecard created by this consultant. If you interested in having a financial scorecard for your company or need help identifying your critical numbers, learning what they mean and monitoring them, contact your area SBDC office.
(Source: Andy Fried, Consultant, UGA SBDC at Kennesaw State University)
