Financial Analysis – Gross Profit & Gross Margin
This video discusses the importance of using gross profit and gross margin to determine your company’s performance, analyze year-over-year changes, and understand how additional sales can impact gross margin.
Thanks for joining Clayton McKervey in a conversation on how to best analyze a company’s financial health. Clayton McKervey is a full service CPA firm focused on helping closely held growth-driven businesses compete in a global marketplace.
Today we will discuss some specific KPIs or key performance indicators that can help you track and measure company performance.
To learn more, check out the videos throughout the series.
In this video, we will be exploring another important barometer of financial performance – gross profit and gross margin. Again another simple ratio but extremely important to understand. This one can certainly enrich your analysis of the other metrics discussed in this series.
So gross profit, what is it? It is a metric used to assess a company’s financial health and business model by revealing the amount of money left over from sales after deducting the cost of goods sold.
So let’s kick it off with an example. We’ve got an assembly manufacturer company. Last year, they had revenue of approximately six million and cost to sales of 3.6 million. So that would mean that gross profit was 2.4 million and gross margin was 40 percent. So how is this figure viewed externally?
Well, the company generated 2.4 million in direct profit from their sales which means they now have that amount of money that can be utilized to cover operating expenses, provide cash flow to buy new equipment, service outstanding debt or even pay bonuses back to the owners of the company.
Looked at differently, it means that for every dollar of sales the business is generating, on average 40 cents is in direct profit. So how did I compute these? So for gross profit, I took sales, less my costs, equals gross profit and my gross margin, I started with that last figure gross profit, divided it by sales to arrive at my gross margin.
So let’s explore the type of analysis that you can perform with this figure. So as I started off, I had my assembly manufacturer. I had year one’s data. Now I’m going to add in year two. In year two, the assembly manufacturer grew by adding a half million dollars in revenue from the year prior and its cost increased to 4.2 million.
So from this figure, gross profit for year two is $2.3 million and gross margin would equate to 35 percent. So what does that mean? My assembly manufacturer grew their sales. All things considered, a good thing. However, overall profitability derived from the actual sales less their costs declined.
So the manufacturer now wants to look at and forecast year three. By looking at this analysis over the past two years, what values, levers or insight can be analyzed and pulled? Well, management could take a look at the following.
Was for example there a new product offered in the second year that was new to the company and therefore had a significant element of learning involved in the delivery of a certain product or machine? And for example, is that same type of learning expected to repeat into year three if we sell that same product again or during year two, did something deviate from plan as I was building one of my machines that caused the material to be scrapped?
And again looking at this from a year two to year three perspective. Am I expecting that sort of material to be scrapped again if I have to build that same machine or looking back at year one and two, do I find out by looking at this hey, year two, the lower growth profit, is actually more indicative of what’s to come and therefore was I possibly missing a cost from my first year?
Even more significantly, did something deviate from a customer’s original scope of work whereby additional time and material was needed to finalize that product known as scope creep and was that scope creep actually properly identified and billed?
As you can see, the power of this analysis expands, the more data you have, especially the frequency in which that data is reviewed, as items such as scope creep can sometimes only be billed if they’re identified timely.
So let’s expand this by pulling in a comparison. So we’ve got two manufacturing companies, manufacturer A and B. Manufacturer A has 11 million in revenue, 10 million in costs, 1 million in profit, equals 9 percent gross margin.
Manufacturer B has 12 million in revenue, 10.2 in costs and therefore 1.8 million in profit which would give them a 15 percent gross margin.
Further, let’s say both companies operate in the same general area, designing and building similar products.
So manufacturer B, while they only have 9 percent more revenue, they actually have close to 80 percent more profit comparatively or looked at alternatively, the second company has an additional $800,000 in gross profit with just one million dollars more in sales. Lastly, let’s say that the industry average for the product set I’m delivering is actually closer to what the second company is achieving at 15 percent.
If you were the first company armed with this level of data, what questions and analysis could you start to take a look at in addition to the things that we’ve already discussed such as scope creep, waste or even learning on a new type of machine?
Well, for starters, this could indicate that your competitor does a better job of either buying material at lower prices or selling the same product at a higher price. But management in detail could look at the following three things relative to sales, purchasing and operations.
Let’s look at that from the vendor side. Let’s say for example our machine builder uses a lot of robots for the machines that they build and to purchase those robots in the past, you use a number of different vendors.
Well, could you achieve a better price by consolidating to just one vendor or what about buying your biggest cost item those robots used or their products that you are continuously using and therefore could buy in bulk or larger quantities to obtain better pricing or lastly, are there actual quick pay discounts that you could be taking advantage of?
From the sales side, if you were to analyze your data at a deeper, more project or customer-based level, do you actually have a competitive advantage that you didn’t know about, with a specific type of project build or customer base whereby you have opportunities to learn and leverage the knowledge from one group to all of your projects or finally, is there a value proposition missing from your sales process?
Let’s say that while company A and B are in the same industry both delivering machines, only the second company that has the better gross profit is delivering some value add thing such as warranty, installation, support and training or even spare parts, that you could be adding into your mix or from an operation standpoint, you could review some of the following.
What levels of overhead are you carrying? And more importantly, what’s included in your cost to sales?
Let us know your thoughts and thanks for watching.
If you are interested in learning how data analytics can help your business, Clayton & McKervey can help. For additional information call us at 248-208-8860 or click here to contact us. We look forward to speaking with you soon.
This content was also published on the Control System Integrator Association website.