Last year I did a couple of articles on Cost of Sales. The series was a little dry and theoretical and I wanted to follow it up with some practical points about how to monitor and manage your cost of sales so that you achieve as much gross profit as possible and this is something that all of us are interested in. Im not sure why its called Gross Profit, in my mind profit is awesome, not gross?
Before We Start
Cost of sales is made up of any variable costs that are directly related to sales volumes, ie if sales go up then these costs go up. For example, the total cost price of the retail items that you sell.
On the other hand fixed costs remain the same regardless of whether your sales volumes go up or down, for example, rent. Fixed costs are not included in cost of sales.
Some costs have variable and fixed components, for example, a basic salary that is constant plus commission, which is dependent on your sales volumes. The commission portion may be included in the cost of sales calculation whereas the basic salary would not.
Gross Profit, therefore, is the difference between your Sales Revenue and your Cost of Sales (or your variable costs).
Once you have determined your Gross Profit you then deduct all your other operating expenses like rent, telephone, insurance, advertising, ESP I.T costs etc and this will leave you with your Net Profit. And its your Net Profit that SARS is particularly interested in.
The Laws of Balance
When thinking about how I could spice up this topic in order to make it more inspiring and less like a sedative I concluded that people like articles and talks where there is a call to action and a set number of steps. For example, 3 keys to being a good boss, 5 traits of a bad employee, 7 ways to retain your clients etc.
So I was looking for a container or a way to package this topic so that it would be easy to absorb with clear calls to action.
I recalled a series of talks on personal finance by Andy Stanley (www.northpoint.org/balanced) where he compares being financially balanced to the laws of physical balance.
In this series Andy talks about the requirements to balance a pole in the open palm of your hand. First you need an objective, in this case the objective is to keep the pole upright. Without this objective the pole would fall.
Secondly, you need a focus point. In this case the focus point is the top of the pole. If you take your focus off the top of the pole it will fall down. Try this for yourself, take a broom and try and balance it upside down on your hand and take your focus away from the top and notice what happens.
Thirdly, you need to be making constant corrections. If you try this balancing act you will notice that you have to keep moving your hand in order to keep the pole upright. These movements are the constant corrections.
Andy then goes on to explain how this all applies to personal finance and if you get the chance I highly recommend that you check out this online series.
I will now use this comparison between physical balance and managing your cost of sales and gross profit.
First of all we need to define our objective. In this case the objective is quite simple, make as much gross profit as possible (in Rand value).
The goal of any business is to make a net profit, but this is simply impossible if you don’t first make a gross profit.
There’s not really much more to say about this.
In the balancing act, the focus point is the top of the pole. Remember that if you take your eye of the top of the pole it will fall. The focus point therefore is the monthly Gross Profit Margin, both as a percentage and as a Rand value.
One might argue at this point that Gross Profit is directly related to whatever your mark up is on your different supplier brands and so it will be pretty constant. In an ideal world this would be the case but in the real world you will see that it is not.
The outcome that we wish to achieve is that the Gross Profit margin is in fact consistent and if anything getting bigger (ie more profit) as time goes on.
Whenever there are variances that eat into the profit margin then action needs to be taken in order to firstly understand what has caused the variance and secondly to correct it (constant corrections).
Generally you can work on a Gross Profit margin of between 35% and 45% before commission. If you are going to include commission then take off another 10% from the margin. This will depend on the brands that you stock, the price you pay for your stock and the price you sell it for.
Arrange your data into monthly management accounts so that you can get a monthly Gross Profit percentage. Doing it monthly will alert you more quickly to any problems and put you in a better position to take action.
Here is a very simple example of what this might look like:
In this example you can see a Gross Profit Margin that is close to 40% but in one month (May) dropped to 34%. By keeping this as our focus point we can immediately be made aware when we need to make a correction. (note that I have not distinguished between Retail and Service revenue or Cost of Sales at this point, Im really just focusing on Retail).
Ask your accountant to help you in setting up this structure. Explain to them what you are trying to achieve. This will be right up their ally so they should be in full support of the process.
Once you have set this structure up you need to start looking at the constant corrections that you may need to start making in order to keep your gross profit margins at the level you require.
There are a number of things that affect your gross profit margin and would need constant correcting:
Commission paid to staff
In most cases this is fairly straight forward but if you have sliding scales in place then the more that staff sell the higher their rate of commission will become and the less your gross profit margin will become. Sometimes staff members get rewarded not on their retail sales alone but on the ratio between Service and Retail sales. This gets a little more complicated so you might need to run a few scenarios to see the effect it has on commissions and therefore gross profit margins.
If stock is being stolen then this will be eating into your gross profit margins. Because cost of sales is generally calculated as Opening Stock, Plus Purchases, Less Closing Stock it means that all stock that has gone out of the business (whether sold or stolen) is being calculated in the cost and therefore eats into the margin. Therefore you need to be constantly correcting the issue of shrinkage in your business.
If you are discounting then it means that you are selling at a lower value but you are still selling at the same value. Therefore you need to be careful of falling into the trap of over discounting. It is difficult as clients become more price sensitive and the effect of companies like Groupon have had. If you are going to rely heavily on discounting then you are going to need to increase your volumes in order to get the same Rand value in the bank with lower margins.
Choosing your brands
Often times people will change brands because they are not happy with the deal or the discounts they are getting from their supplier. While this makes sense at one level you must consider which brands sell the best because you may recover your lost margins purely by sales volumes. Therefore you need to get the balance right between margin and sales volumes when choosing a brand. Also you need to consider what else your supplier is doing for you in adding value to the brands they supply. This added value may need to be looked at as a savings in marketing costs rather than a savings in cost of sales.
Supplier price increases
If suppliers increase their prices this will eat into your gross profit margins immediately. There are one of two ways to deal with this, increase your own prices but this could scare clients and drive sales down. Or you could leave prices as they are and increase volumes based on a better price.
Because you are buying stock at different times and selling stock at different times the chances are that you will have items on your shelf that you have purchased at different prices. Therefore if you bought one item at R100 and another at R110 you will need to discuss with your accountant what method they are valuing your stock at so that it most accurately reflects your actual stock value because this value is used in determining your opening and closing stock values, which in turn are used to determine your cost of sales.
Do you know what your current Gross Profit Margin is? Do you know what it should be? Are you watching it carefully every month? Do you know what is affecting your margins and are you constantly making corrections in order to improve it?
Use this example of balance by remembering your objective, having a clear focus point and getting to work to make the corrections required.