Simon Jarman, CEO of Clever Bean Accounting, discusses the importance of understanding your gross profit percentage…
I say it repeatedly – businesses are run by their numbers. If you don’t know your numbers, you don’t know your business. One of the most important numbers of all, if not the most important, is gross profit.
Gross profit is what you have left after deducting the costs directly attributable to a project – typically materials, labour, installation costs (including vehicle costs, access equipment and consumable materials) and sales costs.
You then deduct your overheads (costs not directly attributable to a project) to arrive at your Net Profit. Overhead costs typically include staff costs (but not fitters, surveyors, service engineers or manufacturing labour), rent, rates, insurance, office costs, legal & professional charges, bank charges etc. I also usually classify marketing costs as overheads.
Gross Profit Percentage
Even more important than gross profit is gross profit percentage (or gross margin percentage). It’s all very well knowing how much profit you have made in terms of pound notes, but that only tells half the story.
All too often I hear “I made a grand on that job, I’m happy with that”. But what if that job’s sales value was £10k? That means that gross profit in percentage terms is just 10%.
Let’s imagine a £1m turnover business and extrapolate that return for every job – that means a gross profit of £100k for the year – an amount that is very unlikely to be sufficient to cover overheads and as a result the business will be loss making.
The following will vary whether you are a fabricator or an installer, or whether you focus on ali, PVC or timber but as a broad rule of thumb, your gross margin percentage should be no less than 30% of turnover and your overheads no more than 20% of turnover, leaving you with a minimum 10% net profit. Once gross margin percentage falls below 25%, it’s highly improbable that the business will be making money and is likely to run into cashflow difficulties.
But despite this being such a crucial indicator, how many businesses in this industry are monitoring their gross margin percentages consistently (and accurately) every month? Sadly, far too few, and changing this outlook would have a massive positive effect on the industry as a whole.
Now let’s talk about the difference between margin and mark-up, as this is often misunderstood. If you add 30% to your direct costs to arrive at your selling price, have you made 30% gross margin? No, 30% is your mark-up, not your margin.
Let’s take a job with costs of £1,000. If we mark it up by 30%, we will sell it for £1,300 and make gross margin of £300. Our gross margin percentage on this job is £300 divided by £1,300 which equates to 23% which in my view is insufficient. To make a gross margin percentage of 30% or more, your mark-up needs to be a minimum of 43%.
Race to the bottom
A common response to this level of mark-up is ‘that would make me uncompetitive and I’d lose sales’. The conclusion to draw from this is that as an industry we are too focused on competing on price and it’s a ‘race to the bottom’. Ultimately, this is bad news. Squeezed margins means squeezed cashflow and companies going bust. A topic to be explored in another article on another day, but this is something that the industry must address in order to gain long-term prosperity.