As a business owner, you likely started your venture with passion and a vision for success. You’ve worked tirelessly, celebrated milestones, and probably chased after that ever-elusive revenue number, believing that a higher top-line figure equates to a healthier, more profitable business. Many business owners focus on revenue goals because it’s an easy number to chase. However, if you’re finding that high revenue isn’t translating into the profitability you expect, you’re not alone.
The truth is, a high revenue number is meaningless if it is not “profitable revenue” or “quality revenue.” Chasing revenue without a deep understanding of profitability can force you to “forgo profit” or make fixed cost cuts, impacting your long-term stability and ultimately, your peace of mind. For sustainable success and proactive decision making, you have to understand your GPM (Gross Profit Margin).
The Misleading Nature of Revenue
It’s natural to be proud of a growing revenue stream. It feels like progress, a validation of your hard work. However, the pursuit of a revenue goal, while superficially appealing, can distract from the true health of your business. Businesses can generate substantial revenue but still struggle to cover their operating costs, leading to a constant scramble and financial stress. If your revenue isn’t profitable, you’re essentially working harder for less, a cycle that can lead to burnout and even business failure.
Defining and Calculating Gross Profit Margin (GPM)
To take control of your financial destiny, you must understand Gross Profit Margin (GPM). Simply put, Gross Profit Margin is your revenue minus all the costs specifically associated with generating that revenue. These are your direct costs, the expenses that fluctuate with each product sold or service rendered.
The types of direct costs typically included are:
- Labor: Wages for employees directly involved in producing goods or delivering services.
- Materials: Raw materials or components used in production.
- Subcontractor Costs: Payments to external parties for work directly related to your projects.
- Equipment Rental: Costs for equipment rented specifically for a job.
The primary purpose of GPM is to ensure that every job, every product, and every service you offer helps cover the business’s annual fixed costs (overhead). To set a meaningful GPM goal, we look at your prior year’s total overhead costs and revenue to determine how much income you need to add to cover these fixed expenses.
Use Your GPM to Achieve Consistency
When reviewing financials, there are clear red flags that highlight a need for deeper analysis. The consistency of your GPM is a key indicator, especially if your financials are accounted for on an accrual basis. Inconsistent GPM figures can signal problems with cost tracking, pricing, or even the fundamental profitability of your offerings.
If your GPM doesn’t cover your overhead and your net income percentage is 5% or less, you must seriously consider whether the headache is worth it. A business that barely breaks even, despite high revenue, can feel like a tremendous drain on your time and energy—especially when you know your true potential.
Do you have plans to sell your business eventually? A potential buyer needs to see a 3-5 year trend showing consistent profitability. This demonstrates stability and a well-managed operation, making your business a more attractive investment.
GPM as a Proactive Pricing and Decision Tool
Understanding your GPM empowers you to be proactive with your pricing, rather than reactive. Instead of guessing, you can make informed decisions that directly impact your bottom line.
For example, if you face increased costs due to minimum wage hikes, new paid sick leave requirements, or mandatory retirement contributions, knowing your GPM allows you to adjust your rates accordingly. You can confidently raise prices, knowing precisely how much you need to increase them to maintain your desired profit levels.
GPM also helps you identify your most and least profitable services or clients. This requires “dedication to coding everything, entering information correctly,” and stratifying customers/services in your accounting system. By meticulously tracking costs and revenue for each segment, you can see which areas are thriving and which are dragging down your overall profitability. This data enables you to make strategic decisions, such as focusing on high-margin services or renegotiating contracts with less profitable clients.
Review Frequency and Actionable Steps
To harness the power of GPM, consistent review is paramount. GPM should be reviewed every single month (both month and year to date). Beyond the monthly check-in, you want to study it closely at year’s end to avoid running on autopilot. This deep dive at year-end provides valuable insights into annual trends and allows for strategic adjustments for the coming year.
Once clients understand their GPM, they typically take several actionable steps:
- Right-size their pricing: They adjust their rates to accurately reflect their costs and desired profit margins.
- Stop taking unprofitable projects: They learn to say no to work that, despite generating revenue, ultimately drains resources and time without adequate return.
- Look at overhead costs to identify savings: They scrutinize fixed expenses, seeking opportunities for reduction, such as cutting an expensive lease or consolidating credit cards to reduce interest payments.
What Would It Mean for Your Business?
For the overwhelmed business owner, the first steps towards financial control involve standardizing processes and ensuring the profit & loss statement is set up correctly. This foundational work will provide the clarity needed to begin tracking GPM effectively.
Tracking GPM provides essential control, allowing you to see the benefit in your bank account. This tangible evidence of your efforts translating into actual profit reduces stress and brings a profound sense of peace of mind. By embracing GPM awareness, you unlock true financial control and pave the way for sustainable business success.
Contact Advantage Insights to master your GPM and unlock sustainable profitability.
