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So What’s Your Gross Profit?

May 5, 2011 Finance

We often hear business owners say that their gross profit (or gross margin, to some) is a certain percentage of sales; say 40%.  And sure enough, when we use their price list and their item cost report to make the following calculation:

(Sales Price – Unit Cost)/Sales Price

We get a figure very close to the claimed 40%.

Then we look at the company’s income statement and find a percentage far below the claimed percentage, like 34%.  What happened!?

Here are a few examples of why the numbers can be so different:

Discounts and Allowances: If the list price says $10 per item but the majority of customers get a 5% discount, the net sales price is really $9.50.  Instead of calculating the gross margin as:

($10 sales price – $6 unit cost)/$10 sales price = 40% gross margin

The real calculation is:

($9.50 sales price – $6 unit cost)/$9.50 sales price = 37% gross margin

Inventory Shrinkage: All businesses which maintain inventory experience shrinkage.  There are an almost unlimited number of ways that companies can lose inventory, but a few of the major culprits are:  employee theft, vendor theft, shipping errors, receiving errors, portion control, bill of material errors, accounting errors, etc.

Businesses need to take normal shrinkage into account when reporting gross profit numbers, and should get in the habit of tracking shrinkage separately from regular cost of sales to highlight the amount of shrinkage being experienced.  One thing is for certain:  if shrinkage is not tracked, it will get larger.

Samples, office use, etc.: Admittedly, it is a pain in the neck to keep track of items pulled from inventory for samples, office use, holiday gifts, etc.  If these reductions from inventory are not tracked and appropriately recorded (i.e., as marketing expense for samples), their cost simply ends up reducing gross profit. On 100 sales of our hypothetical $10 item, two samples pulled from inventory reduces gross profit from 40% to 38.8%.  Tracked correctly, the margin stays at 40%.

So what is the big deal about your numbers being different?

  • You approach a banker/investor with claims of 40% gross margins and follow that up with an income statement showing 34%…you are immediately on the defensive.
  • You price your product assuming a 40% gross margin and then are surprised when you realize less than that.
  • You do your budget or business plan based on a 40% gross margin, realize less than that and wind up needing more cash than you anticipated, and maybe more than your line of credit can support!

Improving accounting procedures and clarity of communication can reduce the likelihood of having negative surprises.  Instead of,  “We make 40% gross profit” how about,  “Our list prices are based on a 40% margin, and we generally realize a 34% gross margin after discounts and inventory adjustments.”  The latter is more realistic and shows that you truly understand your business.

Fahrenheit Finance can help you understand your true gross margin and other critical metrics of your business.  Contact Doug Jones at djones@fahrenheitfinance.com for help on your particular finance and accounting concerns.

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