Without a strong Gross Profit from your business operations, having a strong Net Income number is impossible.
Overview
Gross Profit measures your first level of profit contribution that comes from transforming a dollar of sales into a profit. Gross profit is calculated by subtracting the direct costs incurred to produce a product, complete a job, or deliver services, from Net Sales.
Your Gross Profit percent of Net Sales, also referred to as the Gross Margin Ratio, is the best determiner of how efficiently your operations convert sales into profits. If your percent of Gross Profit earned on every dollar sold isn’t improving noticeably, year-over-year, then your business operations aren’t becoming more efficient. A Gross Profit that is continuously improving is the best reflection of a well-managed business.
An unhealthy Gross Profit results in a continuous struggle to keep sales greater than the cost of production. If sales are not greater than COGS, money will never be left over to pay operating expenses and provide the owner with profits.
The most efficient way to increase Gross Profit is to hold your direct costs while increasing your selling price. The higher prices drop straight down to the bottom-line as long as there isn’t a corresponding increase in business costs to justify the higher prices.
The other option is to reduce direct costs as a percentage of sales. The lower cost of goods sold will produce higher Gross Profits because you deliver your sales at a lower cost.
Consider the profit impact of reducing the most expensive area of your operations by 8% and how much more Gross Profit dollars your direct operations would produce. Now consider increasing your prices by 2% while holding your COGS as a percent of Net Sales. How much more Gross Profit dollars would you have to pay your overhead expenses?
Your math results will confirm whether increasing Gross Profit by increasing prices or lowering your largest COGS item is better. The next decision is to determine who is the best person to be accountable for taking the decided action to increase the value of Gross Profits.