Sunday, April 24, 2016

Why is the Gross Margin one of the most important things to watch? Client Question- David C Barnett

Hi there again, It’s David Barnett from  This week I was asked what I thought was an important number to keep an eye on when managing a business.  Watch the video here:  My answer was: the gross profit (or gross margin.)  Why?

Simply put, the business can’t function over the long term if we don’t charge the right price for our product or service.  The gross profit is what is left over after we pay for the direct expenses of serving the customer.  In construction this would be the tradesmen and the materials.  In a restaurant it would be the cost of the food and paper supplies. 

The problem we run into when we have an income statement which simply has a sales figure and then all the expenses deducted is that we can’t verify that our pricing is correct over a short period such as a week or a month.  In the video, I demonstrate with an actual income statement like this.  If it’s impossible for a business manager to constantly check and ensure the target gross profit is being met, then problems can creep in over time.

For example, you may implement a pricing strategy that is used to quote projects.  If the cost of your supplies and labour are slowly creeping up and you don’t change your pricing formula, the gross profit will start to shrink.  This may mean shortages of cash to pay bills.  You may mis-interpret this as a receivables problem when in reality it’s a margin issue.  Most worrisome is the fact that businesspeople who don’t actively manage from their financials often are unaware of issues until they are pointed out in annual financial statements.  This could mean trying to respond to a problem up to 18 months after the issue has begun.

If an income statement is set up properly, a good manager can check weekly or monthly and make sure the gross profit is on track.  Other issues can also become apparent.  The video was inspired by a conversation with a UK businessman who thought his business had suddenly become more profitable.  He thought it was great.  What he didn’t realize was that one of his suppliers had neglected to send him some invoices.  When they fixed their oversight, he had put himself into a hole by spending money that really wasn’t his.

If his income statement had been properly structured and he was reviewing it weekly, he would have noticed the sudden drop in costs.  This would have led to inquiries and the billing issue would have been discovered before he spent the money on something else.

Now what about all those overhead expenses that have to be paid for out of the gross profit?  Well if the gross profit is under control and day-to-day operations are profitable, we can then examine the overheads on a regular basis to see if any start to get out of line. 

Another big reason to have a properly structured income statement is so that a potential buyer can easily compare the business to peers.   This is called benchmarking and it’s an important part of the evaluation process.  If the business activity is transparent and easy to understand, the business can be better managed and can be sold more expediently.  It’s also likely to fetch a better price than an equivalent business with more muddled books.

If you’re interested in learning more about buying and selling businesses, managing businesses, or local investing, visit my blog at  While you’re there, sign up for my insiders list and be amongst the first to receive my new videos each week by e-mail.  If you think you may need my help with a project, you can reach me for short consultations at or contact me at (506) 381-8416 or to discuss a project.  

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