The importance of gross profits cannot be overstated. If you’re contemplating a fundraising round or an exit event, then it’s a benchmark metric right up there with ARR (annual recurring revenue), Sales & Marketing Expense/Revenues, and EBIT. Investors want to see gross margins in line with, or better than, industry averages. Say, 60%-70% at least for SaaS firms; a minimum of 45% to 50% for CPG.
On a more practical level, gross profits, or a company’s Net Revenues minus its Cost of Goods Sold, represent the money available to cover a company’s other (operating) expenses. Once you fully understand your gross margin, it’s easy to evaluate the merits of potential expenditures. Take this example:
If your product sells for $1,000 and your gross margin is 50%, then you can cover the costs of an incremental $10,000 expenditure by selling 20 more units (20x $500 = $10,000).
Gross profit figures, evaluated over time, help determine how well a company is managing its costs and marketing its products. A decline in gross profit may indicate a serious problem that needs to be corrected. An increase may be the result of production/purchasing efficiencies and/or price increases.
To properly manage a company’s gross profits, one must understand its two components, Revenues and Cost of Goods Sold.
Revenues refer to the income received from regular business operations. In most cases, it is the money generated by sales of goods and/or services. It is often called the “top line” figure because it is the top line of a company’s income statement.
For the purposes of this blog, Cost of Goods Sold refers to the operational cost of products and services sold. (I will address the expenses directly related to making the sale of those products and services in my next blog about Contribution Margins).
As a general rule, the companies I work with have a pretty good grasp of their Cost of Goods Sold. They understand the costs of materials, outside services, direct and indirect labor. Batch or production run efficiencies are defined. Hosting, AWS, and fulfillment fees tend to be under control. Inflation and supply chain disruptions are more challenging but can be addressed. These same businesses, however, often have a poor understanding of how to price their products and services. The revenue side of gross profit management is haphazard.
Too often, business rely on a very simplistic, cost-plus pricing strategy. “As long as we double my costs, we’ll be fine.” What if your company must commit to a price for 12 months or more? Would you know if your competitors are pricing far higher for the same services? Have you factored in the cost of credit card processing, discounts, and returns? Do you offer various pricing schemes (Silver, Gold, Platinum; or Monthly and Yearly)? The list goes on.
Managing gross margins begins at the top line. Pricing properly is critical, but so is understanding what it costs to generate those revenues. Next week, I will focus on Contribution Margins, or gross profits minus direct selling/marketing expenses. For most businesses, managing Contribution Margin and its related metrics, like Sales Acquisition Costs is absolutely critical to success.