Generating greater profits isn’t only about increasing sales. If your profit margins are being weighed down by unnecessary expenses that are a part of the cost of goods sold, your business could be missing out of a large percentage of your potential gains. Carefully looking into your gross margins is a great way to find potential profit that your business is currently missing.
To provide weekly accounting tips for entrepreneurs, Kahuna Accounting started the “Accounting Clarity for Entrepreneurs” series. Each week, we’ll feature a new how-to video and description based on the questions we get from the many entrepreneurs we work with. Here is “The Basics and Importance of Gross Margins” tutorial.
See below for a full transcript of this tutorial along with large versions of the images used in the video.
“This is Michael Luchies from the Kahuna Accounting team, and this week for the Accounting Clarity for Entrepreneurs series we’re going to be talking about the basics and the importance of gross margins for your business.
Gross margin, which is also known as gross profit margin, is the percentage of revenue you keep after costs of goods sold. We’re going to calculate a gross margin and explain a couple of important things to know about your gross margin using an example of a service based business. First, let’s locate your gross profit margin using Xero Cloud Accounting software, where it’s referred to as simply gross profit. For those of you not using Xero, please don’t worry, we will do an example without using the software that will help you calculate your margin even if you want to use a piece of paper and a pen.
When looking at your dashboard, you want to scroll over to reports, and click on your income statement. Gross profit margin, since it’s related to your business’ income will always be found on the income statement.
You will find your gross profit amount located right above operating expenses. Remember that this number is your sales subtracted by cost of goods sold. Finding the percentage of your gross profit margin will tell you how expensive each dollar of sales is before your fixed expenses, shown here as your operating expenses. This is extremely valuable information because it shows you how profitable your business is per each dollar of sales. Even a slight increase in your profit margin can have an explosive impact on your company’s growth, and we will touch on that here in a minute.
Before we move on to our detailed example, let’s calculate the gross profit margin percentage for this demo company here. To find that percentage, we need to subtract cost of goods sold from revenue, which is 1,168.74. We then take that number and divide it by our revenues of $2,008.74 and multiply that by 100 to get our percentage. This comes to 58.18%, which means for every dollar in sales, the company’s gross profit is 58 cents before that amount is applied to cover operating expense. So when all of your operating expenses are covered, every additional dollar in sales will bring just over 58 cents in profit to your company.
To further illustrate gross profit margins, we made up a company called Solo Graphic Design Company. It’s currently a small one-person agency that creates logos for companies. They charge a flat rate of just $25 a logo and spend an average of 20 minutes on each job, meaning this entrepreneur can create three logos in an hour to earn $75 in revenue. Looking at their fees, they pay $5 per job to the website they market their services to, pay $200 in additional advertising per month and a fixed internet cost of $100 per month.
Now, let’s get into the fun stuff – the gross profit margin for Solo Graphic Design Co. We’re going to use one week’s worth of work as an example. The founder of Solo Graphic Design Co. worked 33 1/3 hours and was able to complete 100 jobs in total. Their total revenue was $2,500. To get the gross profit margin we have to subtract the cost of goods sold.
For simplicity, we’re going to break down a single job, which they can do three of in an hour, to calculate the gross profit margin.
As shown in the previous slide, there is a 20% fee associated with each sale, so that $5 goes into cost of goods sold.
Since the owner of the company does need some money to survive on, they charge $25 an hour for direct labor, meaning that since this work results in the owner needing to get paid this amount, it will be recorded as part of cost of goods sold and not operating expense. If he or she had an administrative assistant for example, that would go into operating expenses and not be part of COGS.
Since we’re calculating the gross profit margin of a single sale and there are three sales in an hour, the direct labor cost for this one sale is $8.33, making for a total of $13.33 of variable cost for each logo sale.
We then plug in our formula to get the gross margin percentage which is revenue minus cost of goods sold, divided by revenue and multiplied by 100. We get 46.68%, which means that for every dollar Solo Graphic Design Co. earns from sales, nearly 47 cents goes to profit before paying operating expense.
Looking at this entire week for the company, you can multiply total revenue, which is $2,500 by the gross profit margin, which is 0.4668, and you see that gross profit before operating expenses is $1,167.00.
We want to keep this lesson fairly short, but before we go, we’re going to show you just a quick example of how knowing your margins and this percentage can help you grow your business. This is where it gets fun for us entrepreneurs who want to see more money coming into our pockets each month.
Remember that 20% fee on each job that’s charged? For this business, that fee comes from using the backend of a freelance website. I used to provide my own services on a website like this that did charge that 20%. The founder of Solo Graphic Design decides he wants to search for other providers, and finds a similar one that charges 12.5% instead of 20% from every sale. Now, instead of taking $5 from every sale, $3.125 is being taken as the fee for each sale. It seems like a pretty small change, but let’s look at our profit margin and what this does to our weekly gross profit margin.
Above is the new gross margin information with the lower fee taken out of each sale. The change shifts the variable cost per job from $13.33 to $11.455, and after we plug this information into our equation we see that our gross profit margin goes up from 46.68% to 54.18%. What does this mean for our weekly sales? It means we take home a gross profit of $1,354.50 instead of $1,167.00.
To sum this lesson up, a small change in your profit margin can have a significant impact on your profit. We often think that the only way to bring in more money is to increase our sales, but that’s simply not true. In this scenario we didn’t add one sale to our equation, but by lowering just one of our fees, we increased yearly sales nearly 14%, which for this small business would be a difference of nearly $10,000.
Your to-do from this lesson is to calculate your profit margin and then look carefully through the expenses that are part of your cost of goods sold. Is there anything you can decrease to increase your profit margin? It’s very likely that there is something you can decrease.
And now we reach our final question: Without decreasing the cost of goods sold in this scenario, how many additional sales would Solo Graphic Design need to make $10,000 in additional gross profit?
857! And since the founder of the company can only complete three an hour, that means he or she would need to work nearly 286 more hours to make the same amount of profit that they could make by lowering that one cost.
We’d like to thank you for joining us today. Once again, this was Michael Luchies with Kahuna Accounting. We’re having a lot of fun working with our accounting staff to answer these questions for you and help entrepreneurs grow their business using bookkeeping and accounting.
If you’re interested in learning more about Kahuna Accounting, please visit KahunaAccounting.com. We work with companies that want to grow and we are truly dedicated to serving entrepreneurs. If you have an accounting or bookkeeping question related to your business, please feel free to send it to me at Michael@KahunaWorld.com.
This has been the fourth tutorial in the Accounting Clarity for Entrepreneurs series, thanks again.”
If you want a system that will easily track all these numbers and present you with the reports, you should definitely consider working with the Kahuna Accounting team of experts. View www.kahunaaccounting.com/growth to learn more.
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