gross margin

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Focus on improving margins before working on growth.

By | 2017-10-21T19:54:49+00:00 October 21st, 2017|Tags: , |

Margin management attempts to manage risk by evaluating both cost and revenue simultaneously rather than as individual units of risks.  Margin management involves the management of revenue, expenses and taxes all simultaneously. Looking at each factor in isolation does not always yield the most margin effective decision. For example, you could have a strategy that raises revenue by $5, cost $3 to obtain and after-tax effect will leave you with $2.55. By thinking of all 3, you could research if any tax credits are available concerning the expense, more effective ways of obtaining the same benefits.

First develop the best strategy best fit for your business and then look for alternative ways to fulfil the requirements of the strategy. A business owner who is too concerned about tax savings, could end up with les profits. Strategy that gives rise to the tax savings might not always be right for your business. Take a look at this calculation:

Strategy First Tax First
Revenue $ 50, 000 $ 50, 000
Expenses $ 10,000 $ 20,000
Net $ 40,000 $ 30,000
Tax (15%) $ 6,000 $ 4,500
After Tax Income $ 34,000 $ 25,500

Even though the tax first strategy allowed the business owner to save $1,500 in taxes, the business owner ended up with $8,500 less after-tax profit. This will not be a problem if the additional $10k was spent on business growth/ sustainability. However, what I see is business owners splurging in other to reduce their tax liability. Keeping $34,000 is a lot better than $25,500. This could be cash you could potentially reinvest in the business. The lesson here is to choose the strategy that will maximize your profits first and then find ways to minimize your taxes.

We will take a look at 3 margins that should be managed within your business:

  • Gross margin
  • Net Profit margin
  • After tax profit margin

Gross Margin

Your gross margin is your revenue less your cost of goods sold. Your gross margin percentage is your gross margin as a percentage of revenue. Your gross margin tells you how much you make after you deduct directly what it cost you to purchase the product and get it ready for sale.

Let us say you buy 1,000 units of widgets for $10 each and you sell them for $40 each. Your direct profit on each unit will be $30. This $30 is your gross margin and it is profit before any other business expenses. The goal of the gross margin is to determine your direct profitability.

At $30 profit per unit, your gross margin percent is 75% (30/40). This means for each unit you sell, you keep 75% of the profits before other expenses are accounted for. Remember, gross margin only has to do with the direct cost of buying and selling the product.

Revenue $40,000 100%
Cost of goods sold $10,000 25%
Gross Margin $30,000 75%

The example above only took into account the cost of the product. But in reality, all expenses used to get the product ready for sale are part of your cost of goods sold. It is important to trace the direct costs of producing a product or a service to that product or service. This helps you accurately figure out gross margin. In a retail business, the cost of goods sold will typically include the cost of purchasing the inventory and any incidental expenses associated with the purchase. In a manufacturing business it will include direct materials, direct labor and manufacturing overhead allocated to the production process.

Cost of goods sold is usually the biggest expense most manufacturers and retailers have.

Net profit margin

Net profit is defined as revenue minus total expenses. Or we could restate it by saying net profit is gross margin minus operating expenses.

Revenue

$40,000

100%

Cost of goods sold

$10,000

25%

Gross Margin

$30,000

75%

Other expenses (Selling & Admin expenses)

$25,000

63%

Net profit

$5,000

13%

In the example above, we can compute net sales either by subtracting cost of goods sold and other expenses from revenue, or by subtracting other expenses from gross margin. Either way we will arrive at net profit. We see percentage wise, this business owner only keeps 13% of the revenue he or she brings in. Whether this is a good or bad number depends on the industry the business owner operates in.

After tax profit margin

Taxes are paid on net profit margin and is computed by subtracting the tax you pay from your net profit as shown below:

Revenue $ 40,000 100%
Cost of goods sold $ 10,000 25%
Gross Margin $ 30,000 75%
Other expenses (Selling & Admin expenses) $ 25,000 63%
Net profit $ 5,000 13%
Taxes (15%) $ 750 2%
Profit after taxes $ 4,250 11%

We see after all is said and done, the owner only gets to keep 11% of total revenue.

It is important you keep track of the tax rate and what tax changes affect your business. Some questions to consider that could help you reduce your tax rate are:

  • Is there any credit available to you are not taking?
  • Are you paying taxes on income that could be deferred to a year when your tax rate will be potentially lower?

You want to examine how your effective tax rate increases over time. The effective tax rate is the rate you actually pay on your taxable income. On the other hand, your marginal tax rate is the rate you pay taking into account your income level. These two often defer because there are tax benefits businesses can use to reduce its actual tax.


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