Increase Your Gross Profit Margin

Gross profit margin might be the single most predictive factor about the success or failure of a business.

Small business owners who don’t understand gross profit margin struggle to pay the bills.

Small business owners that do understand how to calculate and influence gross profit margin run and scale successful companies.

How do you calculate gross profit margin?

Gross profit margin is calculated by subtracting the direct costs required to sell products or services from the price that you charge your customers to purchase those products or services.

Examples of direct costs include:

• The wholesale price of products that you purchase for resale
• Direct labour required to sell products and services to your customers
• Shipping costs to bring products for resale to your business
• Royalty fees charged by your franchisor if your business is a franchise

A direct cost is any cost that can be directly tied to the production of specific goods or services.

Gross profit margin can be calculated as a dollar amount per unit sold or as a percentage.

Improve gross profit margin with different pricing strategies

The price that you set for your products or services is the factor that you have the most significant influence over as the owner of a small business.

There are five common pricing strategies, and each strategy will have a different impact on your gross profit margin.

Cost-plus pricing – this pricing strategy takes the calculated direct costs of the products and services that you sell and adds a markup to arrive at the sale price. The markup represents your gross profit margin.

Cost-plus pricing is a great way to ensure that your business earns a consistent and predictable gross profit margin on units sold.

However, cost-plus pricing considers only your input into producing a product or service and often ignores external factors like competition or your customer’s perception of value.

Competitive pricing – this pricing strategy means setting the price of your product or service to align with what your competitors are charging for similar products or services.

This strategy ensures that you won’t miss out on sales by pricing your products or services higher than your competitors.

But if your competitors have priced their products or services inappropriately and are struggling due to an incomplete or bad understanding of gross profit margin following their pricing strategy may cause your business to suffer from the same mistakes.

Value-based pricing – this strategy means selling your products and services based on how much your customers believe those products or services are worth. Value base pricing places less emphasis on your direct materials or direct labour and greater emphasis on what your customers are willing to pay for a finished product.

Following this pricing strategy should not mean ignoring the gross profit margin calculation.

If your customer’s perception of value is lower than you need to charge to earn a sufficient gross profit margin you should not sell this product or service.

Price skimming – this strategy involves setting a high price for your products and services and then lowering that price as the market evolves and a capture greater market share on future sales.

When your prices are their highest you would expect to be earning a high gross profit margin per sale.

However, you should also expect the volume of your sales to be lower because some customers will not be able to afford to pay the high price. Gradually over time as you reduce your sale price more customers will purchase a product but you will earn a lower gross profit margin per sale.

Price skimming involves balancing sales price and sale volume to find the ideal price point that allows your business to sell the right volume at the right price.

Penetration pricing – this strategy involves selling products or services at low prices at a high volume to generate revenue and gross profit margin.

Penetration pricing requires that you pay significant attention to gross profit margin because the gross profit margin per sale is so small.

You risk selling your products or services at breakeven or a loss if you don’t have a clear understanding of direct costs and gross profit margin per sale.

The value in penetration pricing is that you (hopefully) gain a large share of the market for your products or services and make money by selling at volume.

Improve gross profit margin by decreasing direct costs

There are many ways that you can reduce the direct costs in your business to improve gross profit margin. Here are some suggestions that will increase your gross profit margin per sale:

Hire subcontractors instead of full-time employees – you pay a full-time employee whether they are productive or not. Employees with idle capacity who are being paid while not generating revenue can have a significant negative impact on your gross profit margin.

In contrast, subcontractors are typically paid based on producing an outcome (completing work) rather than based on time.

If the needs of your business don’t support a full-time employee yet consider hiring a subcontractor or fractional employee to complete the work to ensure that your direct labour costs are tied directly to revenue-generating activity.

Connect employee compensation to units of production – your employees need to know how you measure success for their role in your business. Many small business owners fail to educate their employees about what key results areas they need to meet to be successful and to ensure job security.

We recommend establishing key performance indicators (KPIs) in your business, sharing those KPIs with your employees, and providing them with frequent reporting so that they have a great understanding of what they need to accomplish in your business to be successful.

Negotiate lower wholesale prices – your suppliers operate businesses too and they want to earn a profit when they sell you items for resale. But if you’ve been a good customer and a long-term customer many suppliers are willing to provide discounts to maintain a relationship.

Suppliers may not volunteer these discounts so it’s up to you as a business owner to negotiate the best purchase price possible on items that you purchase for resale.

Saving 1% to 2% on items purchased for resale over the course of the year can add up to many thousands of dollars of increased gross profit margin and profitability.

Purchase in bulk for volume discounts – many suppliers will offer discounts when their customers purchase items in bulk. A discount on purchases of large quantities of products for resale is referred to as a volume discount.

If you have certainty that items purchased in bulk can be sold within a short period of time you benefit from the lower purchase price on a per unit basis because each sale will yield a higher gross profit margin than if you had purchased in higher quantities.

When considering purchasing in bulk make large purchases based on certainty and not on potential. Know that the item that you’re purchasing in large quantities is something that your business will absolutely be able to convert into sales to avoid obsolete inventory for items purchased based on speculation that you may be able to sell them.

Improve your inventory management – good inventory management will allow you to avoid purchasing direct materials or items for resale when you already have those items in stock.

Good inventory management should allow you to understand how quickly you turn over your inventory and will guide your decision-making on when to repurchase.

Inventory management can serve to reduce waste as well as shrinkage due to theft by employees or customers.

Revisit gross profit margin regularly

Your business should monitor its gross profit margin on a regular basis.

We recommend scheduling regular reviews of pricing and direct costs/inputs to ensure that your business is not losing profitability over time due to lower sales, higher costs, inflation, inventory shrinkage or theft.

Frequent and up-to-date bookkeeping provides the information you need to evaluate gross profit margin and make better business decisions.

Request a meeting with one of our accountants to review your financial statements and discuss how small changes in your pricing, direct costs and gross profit margin can add up to extra profit from your business.