- Any business needs a proper financial management not only to spend their money wisely, but to also analyse based on previous actions and see whether your efforts are leading to your business's financial success or not.
- For a proper financial management, you need to make sure to know every single financial metric, starting from the differences between gross profit margin and markup and building your way up.
- So, let's go back to basics and go over some of the most important ones in the financial terminology like gross profit margin, net profit, overheads, and so on, and make your financial management a good one.
Small business owners are an amazing bunch of people. You put yourselves out there, week after week, slogging it out, dealing with everything that comes your way. As jack-of-all-trades you have to deal with anything from financial management, customer service, and marketing ..sometimes all in the same hour. The only armoury you have is your skillset stretched across many disciplines.
Financial management skills in your business are not optional, and from what I have seen in small business sector, there is a massive skills deficit. In fact, I would describe the general level of financial management as scary. So many times I hear business owners talking money in ways that warn me that they don’t quite understand what is going on.
Looking in your bank account as an indicator of how your business is going is not sufficient! Some common misunderstandings that I hear regarding financial management are the use of markup, gross profit margin, or net profit interchangeably or misuse of the gross profit, gross profit margin and net profit (all of them happen). Regular reporting is very rare, ratios are uncommon and budgets are a foreign concept.
In an attempt to get you all up to speed, here is a back-to-basics lesson on terminology and concepts for your financial management. (Those of you who are well versed in this, please forgive me.)
Markup is used when you are calculating your prices. Once you have worked out how much it costs you to create your offering, markup is the amount you add on top to reach your sale price. Often it is a percentage or multiple of your cost, such as a restaurant that marks up 4 x food costs.
Profits and costs
The costs to run your business are categorised to make it easier to read your financial management results and make more effective decisions about your business. The basic ones are:
- Cost of sales = any cost that you directly incurred to create your product or service, including materials, parts or wages (only those used directly to create your product or time that you spend to sell it).
- Cost of Goods Sold = the cost of materials to create your offering, including ingredients, materials or parts (no wages in here).
- Gross Profit (GP) = the amount left over from your revenue when you take out the total cost of production (Cost of Sales). This is expressed as the total number or as a percentage of revenue called gross profit margin. e.g. GP $30K from total revenue of $60K is 50%.
- Overheads = expenses that you incur that aren’t related directly to production. These are usually fixed and are more consistent, such as insurance, rent, marketing, fees and wages for non-production activities like marketing, administration or accounts.
- Net profit (NP) = the amount left over from your revenue when you take out Cost of Sales and Overheads. This is your profit before tax. e.g. NP $12K from total revenue of $60K is 20%.
Margins are used when analysing your finances and overall financial management results, often as percentages (like the gross profit margin). The mistake that many business owners make is they confuse markup and margin, but markup is not Net Profit because it still includes some costs.
How to use these numbers
The power of analysing your financial management actions in this way is that you can very easily and quickly check the vitality of your business or individual product lines based on your gross profit margin and other metrics. When looking at your financial management reports you will obviously want to know what is yours first and look at Net Profit, but the gross profit margin will tell you a lot about your business.
Gross profit margin quickly tells you if you need to take action with pricing, costs or efficiency and watching changes in gross profit margin rates each month makes it easy to pick trends before they get out of control.
Case study 1: Service Business
A service-based business that I worked with had monthly revenue of $100,000 with the main Cost of Sales being salaries. Over time, profit had slipped with gross profit margin dropping from 45% to 43%. After investigating changes to wage costs we found that superannuation increases, annual pay rises, and increased travel costs had all contributed. Action was needed to increase prices: accept the decreased profit or reduce costs.
Case study 2: Manufacturing business
One of my old clients manufactured packaging products. When I first met them they said their “gross profit margin” was 20%. After I looked more closely at their accounts I soon realised that it was their Markup that was 20%! So for an average monthly material cost of $50,000 their sales were $60,000 with a gross profit margin of 16.7%. Considering overheads were $15,000 (25%) they were losing 8.3% per month. Prices went up promptly after a better financial management.
What are YOUR relationships with your company's financial management? Do you know the basics? What is your gross profit margin like? Are you losing or gaining?