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If you do not know your gross profit margins and percentages, there is no clear method to know where the company should spend its capital. You do not know which customers are problems, which customers to drop or those to raise prices. You do not know which products are good but more importantly, those that are bankrupting you. You do not and cannot know what business you want to pursue, what you should avoid and whether you are spending capital wisely. Stop and start analyzing today.
You need to calculate your gross profit margins as quickly as possible. Do not waste any more time without knowing these numbers. Bring in outsiders if you must, but find out your profitable items and those which are pushing you towards bankruptcy.
Get this information and use it wisely. Track gross profit by individual customer. Spend the time and money to get this information. You must know which firms are profitable and which are not. You cannot afford to not to know which products and services are profitable or which are not.
If you have no idea how to proceed in getting this information, tell your auditors you want them to bring you a cost detail report or gross profit report that is generated by one of their customers (with names, dates and any personal information blanked out). You want to see the report that others use to guide their businesses. You are missing this every day to run your business. Ask for examples and select the model you want your system to generate for you. When you are at this point, follow the further steps and calculate your gross profit margins starting today.
Steps to determine gross profit (in general):
- Calculate direct material. Determine direct material cost and any outside services you purchase specifically for the job. If you buy material in bulk, calculate the cost of the amount that you used just for this job (including that which fell off as scrap, that material that was ruined, the portions that were separated from the original purchase and will not be used for anything else. Charge all of this to your job including the freight, customs and handling costs included in the original purchase.
- Calculate direct labor. Determine direct labor expense. These are only the people who work directly on this job. Your people might work 10 hours for the day and work on five jobs. Make sure they dictate the split of these hours among these jobs. They must retain a time sheet or time card with jobs differentiated by hours. The setup of the job is included. When the guy is done, and goes and starts doing maintenance, general cleaning or something else, charge him to indirect costs at that point. You have to know how much labor it requires.
- Calculate overhead rates/determine how to apply charges. Analyze your direct internal overhead rates. These are your shipping, quality control, receiving, maintenance and other support functions other than selling and general and administrative (SG&A) people. You must determine how you will apply overhead (assign overhead dollars) to each customer’s job. You can use machine hours, direct labor hours or some other unique variable that measures amount of work and amount of earned income for your industry. (i.e. hours to clean a house, machine hours to assemble all components of an automobile, minutes to make a complicated flower arrangement, time to give dance or piano lessons, etc.)
- Calculate labor benefits. Calculate the real cost of direct labor benefits (i.e. vacation, sick, jury duty, holiday pay, medical insurance, provided tools and shoes and outfits, tuition reimbursement, matching social security, FUTA, SUTA, workman’s compensation insurance, life insurance expense not bought by the employee, etc. — could range from 35% to 50% depending upon the individual labor rate since some of the benefits are fixed which causes the benefit percentage variation as labor rate/hour rises).
- Accumulate results over time: Do not get stuck on these calculations; make good estimates and proceed; their calculation can be changed every month or every quarter if necessary. Get rates set up and apply them consistently. After a few months compare what was used with actual calculated rates and adjust accordingly. Compare actual labor hours versus those estimated to correct the estimating personnel.
- Publish the results and work on the worst: Once you have a month or solid period of gross profit data accumulated, publish the list of worst gross profit customers and develop a plan immediately to raise prices where you find the overall net result for a customer in total is a loss.
- Remember that only you know the customer’s GP is lousy. The cost problem is your fault. It is also your responsibility to carefully turn that around. This may a very good customer that just needs to have pricing adjusted through the sales department. Maybe the problem is only a few products or parts that contribute the most to the losses. Maybe the customer will accept price increases if there has been some time since the last ones. Maybe you can redesign or modify the products in a way that cuts cost but keeps the customer happy. Regardless of the answer or approach, you must raise prices quickly once you know who is at the bottom of the list.
- Analyze GP % results regularly. Insist that all jobs/projects/products must be analyzed monthly. Look at all of your customers’ gross profits results each month and pay attention to the guys that show up on the bottom of the list. Is your problem a product problem or a customer problem? Do not neglect taking action on these guys especially if they are not improving. Your actions will perpetually raise the company’s overall return and redirects sales personnel to focus on profitable customers.
- Stop wasting money on losers. Lure the sales personnel to get higher gross profit margins by rewarding their incentives on gross profit margins higher than a hurdle cutoff rate (i.e. No bonuses paid on jobs less than 20% gross profit, bonuses paid only on a customer with an overall GP % of 15% or above, etc.). You decide the cutoff but do something which gets everybody on board to boost profits. Make it pay to ask for more!
- Tie salespersons’ bonuses to minimum gross profit levels: If you want your employees to take care of these problems, stop paying any bonuses on sales dollars and start on gross profit dollars. Tie your production manager’s bonuses to the net profit. He won’t want to take in any losing jobs and will provide adequate feedback to your sales force. He will turn into Mr. Cheap!
- Analyze bids on GP %s before submission to customers. Before submitting a bid to a company, run the estimated gross profit for the job first to determine if it can potentially grow or is too low to waste time on. If your people tell you they cannot do this before bidding or do not have the time, talk quickly with their department manager. If you continue to get this answer from your employees, tell them you cannot assure they will get an annual pay increase as well. Consider upgrading your department. Never submit a bid without knowing what the cost estimate will be before you open your mouth.
