Is your Business Thriving or Diving? How to Measure and Manage your Continued Profitability

The method for assessing whether your business is thriving, improving compared to last year, or regressing is Variance Analysis, specifically Year on Year analysis. We previously discussed Variance Analysis in another blog the link to which is at the bottom of this post.

To achieve this, you should concentrate on certain formulae that will provide insight into your business's performance. Note: do NOT include VAT in these calculations.

Use these formulae before attempting to calculate your GP Ratio:-

Gross Profit = Total Sales minus ‘Cost of Sales’

Where

Total Sales = Turnover before deducting costs for materials, overheads, labour, or drawings.

and

Cost of Sales = ‘Opening stock’ plus ‘direct purchases/materials’ and ‘direct labour’ minus ‘closing stock’

Direct purchases/material costs are expenses that can be directly tied to the production of specific goods or services.

** if you have returns or give discounts, remember to take these off your turnover or Total Sales to give you Net Sales and use this figure in place of Total Sales.

Gross Profit Ratio

The primary formula for evaluating your profitability performance is the Gross Profit Ratio (expressed as a %) and its subsequent analysis.

(Gross Profit/Total Sales) x 100

What constitutes a good GP ratio? It depends on your business type. Generally, a ratio between 50% and 70% is deemed healthy for retailers, restaurants, manufacturers, and other goods producers.

To monitor your margins, you should establish a benchmark for your profitability ratios after your initial business period and compare it with your budget if one was created. Subsequently, compare each period with the previous one to ensure you're not experiencing a decline. In the UK, the HMRC uses the GP ratio and the NP ratio to audit your sales figures (we will discuss the NP Ratio in another blog post). Variations in these ratios can indicate numerous issues, including undeclared income. They also compare your ratios with those of similar businesses.

What causes changes in gross profit?

Changes in gross profit can result from the following:

1. Sales prices have changed - have you increased/decreased your prices to the right amount? Are they competitive with similar businesses in the area?

2. the unit volume of items sold have changed - has foot-fall to your business changed? have you captured all the sales?

3. The product mix sold has changed if different products have varying GP margins - has this been a conscience decision or a trend that you can profit from?

4. The purchase price of direct materials has changed - Have you found a different supplier? Have you changed your selling price in line with costs?

5. The required amount of direct materials has changed due to factors like scrap, spoilage, rework, or product design changes - have you trained your staff? or lost a key piece of equipment?

6. The amount of direct labour has changed due to altered efficiency levels - Are you using labour when you do not need to use them?

7. The cost of direct labour has changed, possibly due to:

   1. Altered overtime levels - are you paying higher rates for more hours or do you need to consider more staff?

   2. Changes in the employee mix with different pay rates - are you using more expensive employees?

   3. Changes in equipment used - Have you invested in more efficient equipment or lost a key piece?

8. Double-counted inventory during stocktaking - check your stocktaking procedure and ensure it is conducted in the same method each time it is needed.

9. Incorrect units of measure during stocktaking - are you using metric or imperial?

10. Theft of stock or takings

It's crucial for business owners to closely monitor the GP Ratio, as it should remain stable despite any significant changes in sales volumes. If it does change, it's essential to investigate the cause.

Ensure your business plan includes a budgeted GP Ratio so that you can use this as a yardstick and compare it period by period (annually or quarterly).

Further reading Variance Analysis