Is Yours Floating Your Boat?
In the tempestuous seas of business, your turnover keeps your boat afloat, riding the waves of costs that are often threatening to drown it. If your turnover drops then your boat starts to sink and if that isn’t rectified some time soon, then your boat will be swamped and when that happens, disaster will strike.
However, growing a healthy turnover is just one factor that keeps your boat afloat. If the storms fill out to become gales or even hurricanes, then the highest turnovers won’t keep you safe. You need to supplement that ballast with healthy profits. It is the profit your business makes that really floats your boat. The better the profit, the higher it rides above those treacherous seas.
So, how can we get our vessel floating high above the water, safe from those pesky storms. To know that there are some elements you need to understand.
Things To Think About To Keep Your Business Afloat
COGS
When you have a business that incurs costs before it can make a sale, such as manufacturing and trades, understanding that cost of sales (COS) or cost of goods sold (COGS) becomes very important.
For Example, if you sell a widget for £5 but the cost of the components you need to buy to make that widget (COGS) cost £3, then the profit you make per widget sold is £2
The bigger your COGS, (very nasty) the smaller your profit you make from the widgets you create and sell. This is where Gross Profit Percentage also kicks in.
Gross Profit Percentage
Gross profit percentage is a measure of how much money a company makes from its sales after paying for the cost of goods sold (COGS). It's calculated by dividing gross profit by net sales and expressing it as a percentage.
For example, if a company has net sales of £100,000 and COGS of £50,000, then its gross profit would be £50,000 and its gross profit percentage would be 50%.
A high gross profit percentage shows that a company is efficient in producing and selling its products or services and so creates a bigger contribution to cover its fixed costs and generate a net profit.
Welcome to Contribution!
Contribution to Fixed Costs
Contribution to fixed costs is the amount of money that a company's gross profit contributes to covering its fixed costs, those expenses that don't change with the volume of sales, such as rent, salaries, and insurance.
Contribution is calculated using the formula:
Contribution to fixed costs = Gross profit - Variable costs
Variable Costs
Variable costs are expenses that change with the volume of sales, such as the marketing costs, certain utility costs and the cost of shipping, not quite the same as COGS.
For example, if a company has gross profit of £50,000 and variable costs of £30,000, then its contribution to fixed costs would be £20,000.
Net Profit Percentage
Net profit percentage is a measure of how much money a company makes after paying for all its expenses, including COGS, fixed costs, and all other expenses. It's calculated by dividing net profit by net sales and expressing it as a percentage.
For example, if a company has net sales of £100,000, COGS of £50,000, Variable Costs of £30,000 and Fixed Costs £10,000, then its net profit would be £10,000 and its net profit percentage would be 10%.
The higher the net profit percentage, the more profitable the company. Using this example above, just a 1% rise in net profit percentage with exactly the same turnover would add another £900 to the profit, lifting your boat a little higher in the water. Increase turnover by 1% and that final profit figure lifts to £1,900.
(However, it's important to note that net profit percentage can be misleading if a company has a lot of debt, as debt payments are not included in net profit. But that’s a story for another day and I bet you can’t wait).
So what does it all mean? Glad you asked.
How to Use Gross Profit Percentage, Contribution to Fixed Costs, and Net Profit Percentage
Gross profit percentage, contribution to fixed costs, and net profit percentage are all important financial metrics that can be used to assess a company's profitability. By tracking these metrics over time, you can see how your company's profitability is changing and identify areas where you can improve, to make your boat float even higher in the water. Small tweaks in raising turnover and lowering costs can create significant increase to the ‘bottom line’.
You can also use these metrics to compare your company's profitability to other companies in your industry, giving you an idea of how well their boats are keeping afloat. This can help you to see how your company is performing relative to its competitors, giving you some insights when it comes to not only setting your pricing but also those companies that may be a target for acquisition.
That’s also another tale for another day.
For now, I hope that’s helped and you know where we are if you’d like more.