How do you use gross margin % (GM %), (or gross profit %) to run your business? These terms are often used interchangeably but are they often defined differently. Most people define gross margin $, as revenue (or sales) less the direct cost of generating that revenue; and GM % is GM $ as a percent of revenue $ which is the definition we use.

The question is: a) What is GM % used for and why should one care about it? b) What can happen if GM % is not used appropriately?

What is GM % used for and why should one care about it?

a) So what is GM % used for? The answer is for a “for profit business” is to make a profit, which we will define as Net Profit (NP). If one does not make a profit, eventually they will go out of business. NP is equal to GM $ – Fixed Cost. So at a steady fixed cost level, the higher ones GM $ the greater their NP. In general, the higher ones GM % the higher their NP will be, so one normally tries to increase their Gross Profit rate. This can be done by increasing their prices or decreasing their direct cost. Of course if one increases their prices too much, they might also reduce demand unless they can demonstrate that the higher prices they charge is clearly worth it to the client. The concern is will clients overall agree to paying a higher price without losing volume, so that one does not generate any more Gross Margin $ then before. Likewise, if one would lower cost too much they might unfavorably impact quality and/or performance which could again lower volume. So there is delicate balance of GM % that one needs. Various markets and customers react differently so that it is important to know the dynamics of your market as regard to price sensitivity and GM %.

What can happen if GM % is not used appropriately?

b) The next question is what will happen if GM % is used inappropriately? The answer lies in the trade off between GM % and volume to maximize NP. If one increases their GM % and does not significantly reduce volume all is well. But if a higher NM % is more then offset by lower volume and reduces NP that is counterproductive. The objective is to maximize NP not NM %.

Here is an example. Let’s start with a NM % of 20% and volume of $100, so NP $ is $20.

If NM % rises to 25% and volume is reduced to $90, the NP will be $22.50 so the result is better than before. If the volume is down to $75 however, the NP would be $15 which more than offsets the NM % gain. Thus if one is concerned about increasing NM % and does not focus on the more important impact on NP they can make the wrong decision.

We welcome your questions as to the challenges you face in order to grow.

To see all articles in this series please go to http://optimal-mgt.com/blog.

Optimal Management is the premier management consulting company to the staffing industry. We act as mentors to owners and managers to maximize their sales, profits and value of their company. We become an extension of our clients operations and are there for all of their staffing and business needs, from sales, marketing and compensation plans, to finance, M&A, general management and everything in between.

After a long holiday period when most people put business thoughts on the back burner, it’s time to get back to work again. With that in mind let’s gets a conversation going on retained earnings; that is, what it is and what is it good for.

What Is Retained Earnings? Retained earnings is of course the amount of profit you have accumulated in the business and not distributed to the shareholders. It is the sum of how much money you have made since the company was started and not taken out in the form of dividends. It may sound like a boring concept that only your CPA should be interested in, but has some rather important ramifications for the way you can operate going forward. At today’s historically low interest rates, it is a good idea to borrow assuming that your rate of return is decent and you can then finance your growth with cheap money.

What is it good for? Retained earnings allow you to borrow money from the bank. The bank is interested in their degree of risk in lending money which is called debt. One of the ways they measure their risk is how much risk you are taking relative to them taking, i.e. their debt. Your risk is the equity you have in the business which is your retained earnings plus whatever capital contribution was made. For many companies the retained earnings portion is the larger portion. This is known as the debt to equity ratio. If you have a negligible amount of equity and you are asking for the bank to carry the lion’s share of risk it is not likely you will get the loan. Although this ratio varies from industry to industry, and loan restrictions are tighter then before, most banks are looking to take on no more then a 2:1 ratio; that is where they loan $2 for every one $1 in equity, industry ranges go from 0.5 to well above 2, although there are many factors to getting a loan and you would do well to check with you bank to determine what kind of D/E ratio and other conditions that want in order to grant you a loan and then shop around to determine your best option.

Retained earnings also gives you the ability to use your internal cash to finance growth and shore up existing operations without relying on borrowing more then you would like. Say for example that you would like to use your line of credit to finance higher accounts receivable as many companies do. You can then use a combination of your current profits and your retained earnings for other things, such as: open new offices, hiring staff, increase fixed cost, buy equipment, increase inventory and supplies, etc.

We welcome your questions as to the challenges you face in order to grow.

To see all articles in this series please go to http://optimal-mgt.com/blog.