The Best Metric of Success For Companies

The best metric in SaaS —
Contribution Margin
Contribution margin is one of the most important metrics in
SaaS. It looks at the revenue from a certain set of customers (a
cohort) minus the cost of acquiring them and the cost of
servicing them over time. The most common grouping of a
customers is in annual cohorts, in other words, customers
acquired in 2011 are the 2011 cohort, those acquired in 2012 are
the 2012 cohort, etc.
We found only 8 publicly traded SaaS companies that even

mention contribution margin in their public filings, and the
quality of disclosure about contributions margins varied and
limited. For instance, Box disclosed the least about their
contribution margin while Coupa Software disclosed the most.
The data was still quite valuable and below is a summary as well
as some observations.
-You will lose money on the customer in the first
year. The cost of a customer in the first year is especially high
because it includes not only the cost of customer
success/customer service, but also the marketing and sales
expense to acquire the customer. As a result, no SaaS company
in the data set makes money on the customer in the first year.
Contribution margins in the first year for MobileIron, Mind
Body, Coupa Software, Okta, Workiva, and Mongo DB were -
28%, -254%, -249%, -93%, -81%, and -111%. As you can see
some SaaS businesses like Mind Body and Coupa Software lost a
lot of money in the first year of acquiring the customer, so it’s
critical they not lose the customer in subsequent years in order
to earn a profit.
-By the 3rd year, the customer is thoroughly

profitable. In the table above we show the cumulative
contribution margin after 3 years for those SaaS companies that
provided that much data. Mobile Iron’s cumulative contribution
margin was 22%, Mind Body was 5%, Coupa was 21%, Okta was
17%, Workiva was 45%, and MongoDB was 15%. Said another
way, by the third year Mobile Iron generated $1.28 in revenue
for each $1 in cost, Mind Body did $1.05, Coupa did $1.26, Okta
did $1.21, Workiva did $1.81, and Mongo did $1.17.
-After the first year, contribution margin is

consistent. In the first year, contribution margin is negative
because it includes the cost of acquiring the customer. After the
first year, all that is left is servicing the customer, so
contribution margins tend to show great consistency. Only
Mobile Iron shows volatile margins after the first year.
Excluding Mobile Iron and Box, we see contribution margin
after the first year falling somewhere between 60% and 75% for
the companies above, a typical fully baked SaaS margin when
including the cost of customer service/customer success.
Contribution margin is difficult to measure, but an imperative
metric for understanding the health of your SaaS business. Make
sure you monitor it for each customer cohort annually.
https://medium.com/@sammyabdullah/the-best-metrics-in-saas-contribution-margin-989c667db60f
The margin
metric that
matters and how
it can improve
your profitability
Guru Hariharan | Aug 22, 2016
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Margin analysis first identifies areas where gross and

contribution margins are not aligned and then isolates the factors
that have the biggest impact on margin at the SKU or category
level.
Most retailers are struggling to maintain profits because product

assortment is expanding while margins are shrinking. Retailers
fighting that battle by tracking gross margins are wielding a butter
knife against the automatic weapons online discounters have been
using for years. Want to level the battlefield? Say hello to your new
weapon: contribution margin analysis.
Gross margin vs. contribution margin
We might as well call gross margin the mythical margin. Like a

mythical beast in a grainy photograph, when we investigate, it
disappears. The reality is that cost of goods sold is only one of dozens
of factors that affect margin, any one of which could tip the scale into
loss instead of profit.
Figure 1: All of the things eating margins
Despite a lengthy list of contribution margin factors, the 80-20 rule

applies. For any given product category, a handful of items drive most
of the impact on margin. Here is a sample equation:
Contribution margin = offer price – PO cost – shipping cost +

shipping revenue – inbound freight + vendor allowances – coupon
rebates
Analyzing contribution margin opens up new opportunities to improve
profitability in the areas of price optimization, vendor negotiation,
marketing performance and shipping and inventory management.
Pricing optimization and vendor negotiation
Figure 2 illustrates the story of profitability as gross margin vs.

contribution margin using a children’s backpack as an example. The
line representing gross margin might stay flat while the contribution
margin can fluctuate above and below the line of profitability.
Figure 2: Sample SKU for a children’s backpack
In another example — Figure 3 — Jet.com offers free shipping for a 24-

pack of Nestle Pure Life Purified Water, but, because this item weighs
25 pounds, the shipping cost most likely outweighs the price of the
water itself, as reflected by competitors’ pricing. On the surface, a
gross margin analysis could show a case of bottled water to be a strong
performer for Jet.com, but a contribution margin analysis reveals the
true story. If this SKU is a frequently purchased item, Jet.com might
want to improve contribution margin by charging shipping or use
another tactic to make sure this is only offered to new customers who
they can make back the cost on over time.
Figure 3: Cost contribution of shipping for bottled water
Margin analysis first identifies areas where gross and contribution

margins are not aligned and then isolates the factors that have the
biggest impact on margin at the SKU or category level. Armed with this
information, retailers can optimize prices to compensate for
previously hidden costs and negotiate with vendors to tilt the cost-
structure battlefield in their favor.
Managing inventory
Accelerated product lifecycles and market demand for wider

assortment can bloat inventory. Because inventory holding costs can
have a significant effect on contribution margin, analysis can identify
opportunities to maximize profitability (see Figure 4).
Figure 4: Shipping and inventory scenarios with matching strategies
given market position and costs
For items where inventory is high and the contribution margin is low,
retailers can cut prices to clear out low-margin product to optimize
inventory real estate. Or they can return the stock to the vendor to
contain the potential loss. Inventory analysis can also flag high-margin
items that are under-stocked, enabling retailers to strategically
manage inventory.
Managing availability per channel
For omnichannel retailers, the cost structures can differ significantly

between channels. Through contribution margin analysis, we can
improve margins by stocking each item in the channel that will
maximize profit and by pricing it appropriately for the channel.
Figure 5: Online versus in store costs
Returning to the issue of prohibitive shipping costs, as with the bottled

water example in Figure 3, retailers could offer it as an in-store-only
item. Another strategy is to leverage the differential in contribution
margin costs between channels. Suppose a free-shipping cost model
drives the price of a toner cartridge 25 percent above your
competitor’s price. Contribution analysis shows that the inventory
holding cost for this item in a brick-and-mortar store is significantly
lower than the shipping cost for the online store. By pricing a mobile-
only, in-store pickup deal below the price of their competitors,
retailers can capture the sale while simultaneously driving traffic to
the local store.
Fight to Win
When planning a strategy, gross margin is a blunt weapon with limited

reach. Instead, contribution margin is the automatic weapon that can
target competitors with surgical accuracy. All of the heavy lifting in
contribution margin analysis is automated, freeing retailers to focus on
strategy and tactics. And that’s a winning strategy.
Boomerang Commerce provides price-optimization technology and

competitive intelligence for online retailers and brands.
https://www.digitalcommerce360.com/2016/08/22/margin-metric-matters-and-how-it-improves-
profitability/
Contribution Margin Vs. Gross Profit

by Hunkar Ozyasar
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Many business owners get so caught up in increasing sales that they lose track of how profitable
those additional sales actually are. It may not be easy to guesstimate how your sales proceeds
will trickle down into your bottom line, especially when you heavily discount your products, or
throw in perks such as free shipping or extended warranties. This is where gross margin and
contribution margin come in.
Gross Profit
Gross profit equals net sales minus the cost of goods sold, and it is the lifeblood of any business,
large or small. In this formula, net sales equal gross sales minus sales discounts and returns. The
cost of goods sold equals the total amount of money directly spent to manufacture and deliver the
goods, or to deliver services. The cost of goods sold excludes indirect expenses, also known as
overhead costs, such as advertising, taxes, and research and development costs. Overhead
costs are later deducted from gross profit to arrive at net income. Since every firm has overhead
costs, net income is always a smaller number than gross profit. In short, a company that isn't
making enough in gross profit won't be able to pay its bills, and therefore can not long survive.
Gross Margin
Gross margin represents the percentage of net sales that the firm takes in as gross profit. It
equals gross profit divided by net sales. If you have sold $500,000 worth of product, and the cost
of goods sold is $300,000, the gross profit is $200,000. The gross margin is $200,000 divided by
$500,000 which equals 40 percent. A business should not focus on gross margin exclusively,
since you can increase gross margin but end up with less in gross profits. If your gross profits
drop to $170,000 and sales decline to $400,000, gross margin would be higher, at 42.5 percent,
yet gross profits would be $30,000 lower.
Contribution Margin
Contribution margin is a more relevant measure to assess the profitability of additional products
sold, and only takes into account variable costs. Contribution margin equals net sales minus
variable product costs and variable period expenses. In simpler terms, you deduct all expenses
from sales that directly increase when volume is scaled up. The rent you pay for your factory is
factored into gross profits, for example, but since the rent doesn't increase when you produce
more, it isn't a variable cost, and therefore is not considered when you calculate the contribution
margin. Similarly, the gasoline used to deliver products to retailers is a variable expense, while
the insurance of the trucks is not.
Relevance
The gross profit gives you an excellent sense of a company's big picture, and tells you if its
overall pricing strategy makes sense. If gross profit is insufficient, you should consider raising
prices, lowering production costs, or both. The contribution margin tells you how you should
evaluate incremental sales. If, for example, the contribution margin is $400,000 and you sold
100,000 T-shirts, each T-shirt contributed $4 to gross profits after all variable costs are deducted.
An additional order of 100 T-shirts will bring in $400, and is not worth it if the hassle involved does
not justify this income. When you must offer a very competitive price or thrown-in extras to get the
business, contribution margin is a highly useful measure of effectiveness.
https://yourbusiness.azcentral.com/contribution-margin-vs-gross-profit-2842.html
What Could Cause an Increase in Profit Margin?

by Scott Shpak; Updated April 23, 2018
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Profit margin is, at its core, a simple equation. Expressed as a ratio, profit margin subtracts the
cost of expenses from total sales revenues, then compares this result to the same sales total.
Therefore, any change that increases sales or decreases expenses results in an increased profit
margin. Perhaps the most used accounting tool to analyze profit margin is the income statement.
About the Income Statement

Calculating profit margin requires an analysis of both revenues and expenses, information you'll
find in the common accounting tool called the income statement. Covering a defined period,
typically a week, month, quarter or year, depending on the business and intended recipient, the
income statement provides both direct and deductive data that’s valuable when determining the
factors that can increase profit margin. However, the standard format for an income statement
usually includes two profit values, gross and net profit.
Gross Versus Net Profit

The simplest calculation of profit subtracts the cost of goods sold from sales revenues for a
product or service. This is called the gross profit, because it doesn’t consider revenues from non-
sales sources, fixed expenses – also called overhead – or one-time costs. Typically, this is the
upper section of the income statement, reflecting core operations performance.
When additional revenues and expenses are added in, usually in the bottom half, the calculation
determines net profit. This includes all aspects of the company’s financial performance.
Revenue Increases
When sales increase, profit margin potentially increases, if the cost of goods sold remains at a
constant percentage of sales. Raising the price per unit while cost of goods stays constant
produces the biggest profit margin gains.
Selling more units may have a similar effect. If it costs more per unit to acquire raw materials,
however, the extra sales may not create a profit margin increase. The biggest gains are made
when fixed expenses remain at the same dollar amount, a condition that adds a dollar-for-dollar
increase to the net profit margin.
If the company has revenue from activities not related to core business, such as investment
income, for example, this revenue adds to the profit margin. Again, it's usually on a dollar-for-
dollar basis, with increases reflected on the bottom line and in the profit margin.
Expense Decreases
Reducing the cost of goods sold improves gross profit margin, if sales revenue remains
consistent. Likewise, decreases in fixed expenses add to bottom-line profit and increased net
profit margin. A company facing profitability challenges may look at reducing administrative
expenses, such as accounting or human resources staff, because these departments typically
don’t add revenue to the business.
Trends in Managerial Accounting

by John Freedman
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Trend analysis, the examination of business metrics over the course of time, is popular in
managerial accounting. By looking at numeric trends, small-business owners can assess
business performance and look at ways to make the business better. Understanding some of the
most common trend analysis metrics in managerial accounting can help you look at the some of
trends in your company and make data-driven decisions to improve your business.
Sales
Many small businesses analyze their sales trends. In most cases, managers are looking for a
positive trend in sales over the prior year. However, this may not be that informative. For
example, if the general economy is poor, even the most successful companies may be
experiencing reductions in sales. In this case, positive sales growth may not be a realistic goal.
On the other hand, if the economy is doing well, the best companies may be enjoying large levels
of sales growth. In this case, positive sales growth may be misinterpreted as successfully
capturing potential sales, when this may not be completely the case.
Costs of Goods Sold

Both merchandising and manufacturing companies often track trends in the company's cost of
goods sold. For merchandising companies that have a stable mix of products sold, increases in
cost of goods sold can signal paying higher prices for items that will be resold or a problem with
inventory management, such as shrink. Shrink is a term for inventory that you can't account for
during an inventory count. The usual assumption is that someone either outside or within the
company has stolen this inventory. For manufacturing companies, trends in cost of goods sold
can be more difficult to analyze. Increasing manufacturing costs could be related to increasing
materials, labor or overhead costs or excess usage of these items.
Net Income
Parties both internal and external to the business often examine profitability trends. However,
profitability in a small business is usually looked at differently than that of large publicly traded
companies. While large companies often express profitability in terms of meeting or beating
analyst forecasts of earnings per share, small businesses often are more concerned with
maintaining a trend of increasingly profitable accounting periods. Other owners seek a stable and
predictable pattern of profits. However, in almost all cases, small-business owners seek to make
a profit each year.
Conversion
Especially common in retail companies, conversion is the ability of a company to make a sale to
someone who visits a retail location. For example, if 10 people came into your store and you were
able to make a sale to five of these potential customers, your conversion rate would be 50
percent. Companies often track trends in conversion to assess the effectiveness of sales staff. In
addition, conversion metrics can provide additional information to explain changes in sales. For
example, if the sales trend is decreasing with the conversion trend, then sales decreases are
unlikely to be fully explained by reductions in people shopping at the store but might be better
explained by an ineffective sales staff.
What Is CVP in a Company?
by John Freedman
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CVP analysis, or cost-volume-profit analysis, is used in managerial accounting to use the

relationships between cost, volume and profit to quickly calculate metrics that provide insight into
the current and future performance of a business. Small-business owners can find CVP analysis
useful, as it is mathematically simple, but it provides information that would otherwise require the
production of an entire budgeted income statement. Learning CVP analysis techniques can save
small-business managers a good deal of time without any loss of information.
Break-Even Analysis
One of the most common CVP analysis techniques is break-even analysis. When a small-
business owner conducts a break-even analysis, he is determining the level of sales or units sold
that would result in exactly zero profit. While zero profit is rarely a goal of small-business owners,
knowing what level of sales results in break-even can be useful. For example, once a company
reaches the break-even point in sales, the company has made enough money to cover all of the
firm's fixed expenses. Therefore, each additional dollar of sales contributes a set amount to
overall profit.
Target Profit
Companies often use CVP analysis to determine the level of sales needed to make a target profit.
This is especially common as small-business owners determine if the profits from the business
are large enough for the owner to quit an outside job. Small-business owners who use target-
profit analysis for this purpose should be careful. CVP techniques assume that fixed costs do not
change and that product sales levels stay the same. If these assumptions are not correct, then
the reliability of the analysis is suspect.
Margin of Safety
The margin of safety is the number of units, sales dollars or percentage of sales dollars above the
point that a company breaks even. In general, companies are looking for a margin of safety that is
as large as possible. A declining margin of safety over time tells small-business owners that costs
are increasing, sales are decreasing or both. As such, it is relatively common to see the margin of
safety calculated on a regular basis and plotted over time.
Evaluation of Alternatives
CVP analysis can also be used to evaluate alternative actions quickly. For example, a company
may be deciding whether to sponsor a charity event. The company's marketing department
predicts that sponsorship of the event will increase sales by 10 percent for the next period, cost
$5,000 and decrease the cost of another marketing program. With this information, CVP analysis
can be used to examine how these pieces separately affect company profits. Without these
techniques, managers can still produce budgeted financial statements to analyze the decision,
but the process is much more cumbersome.
What Is Considered a Good Gross Margin Percentage?

by Neil Kokemuller; Updated April 13, 2018
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While effective gross margin is important to bottom line profit, a "good" gross margin is relative to
your expectations. For example, 30 percent may be a good margin in one industry and for one
company, but not for another. Typically, companies look at industry norms and previous company
financial performance when setting gross margin goals.
What is Gross Margin?

Gross margin is a simple financial ratio that shows how much of your periodic revenue is left after
you subtract costs of goods sold, or COGS. On a monthly revenue of $40,000 and COGS of
$25,000, your gross margin is the $15,000 gross profit divided by the $40,000 revenue. This
equals 0.375, or 37.5 percent. In essence, 37.5 percent of your revenue remains after COGS are
removed, and before you remove operating costs and recognize irregular revenue and expenses.
Industry Standards
You can often find typical industry margins in publications or industry reports. For public
companies that publish quarterly income statements, you can also look over their financial data
and compute margins of top competitors. In general, if your margin meets or exceeds that of
leading providers, you are operating relatively efficiently. If not, you may need to cut variable
costs, boost prices, and improve marketing efforts. Industry standards vary because some
industries with few competitors and luxury items can maintain higher gross margins than more
competitive industries with greater supply of necessary products.
Historic Trends
While you compete against other industry players for profitable earnings, you also compete
internally to improve your profitability over time. Some new businesses have subpar margins by
industry standards because they enter at lower price points to build a customer base. Over time,
you want your margins to equal prior performance or improve. This result is a common sign of
financially healthy and growing businesses. A more established company with falling margins
may be in a decline or on the verge of one, and in desperate need of product or market
diversification.
Margin Stability
Margins are relatively stable for some business models and very unstable for others. The
expansion of big box online retailers and online retailers in general has tightened margins in
many industries. The Economist notes the trend of tighter margins and free shipping expectations
driven by online shoppers in a 2017 article. Product margins are more stable when attached to a
service. A mechanic for example, will charge a set hourly rate plus the cost for parts. The margins
on the parts are stable because they are attached to the service bill.
What Does a Low Gross Profit Percentage Mean?

by Neil Kokemuller
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Gross profit equals your revenue in a period, minus your costs of goods sold. Your gross profit
percentage, commonly known as gross margin, equals gross profit divided by revenue. It is a
measure of your small business's ability to efficiently turn revenue into profit. A low gross profit
means that relative to industry peers, you struggle to create profits on sales.
Basics
For a manufacturer, gross profits result when you sell goods for more than what cost you to make
them. Materials, variable labor and equipment costs are examples of manufacturing cost of goods
sold.
For resellers, gross profits result when you resell goods to consumers for more than they cost you
to acquire them. Gross profits are necessary to earn bottom-line net profits; they must exceed
fixed costs and any irregular costs during the period.
Industry Standards
As an example of the gross margin calculation, assume a periodic revenue of $50,000, less cost
of goods sold of $30,000, which equals gross profit of $20,000. Your margin is 40 percent. You
don't really know whether this is relatively high or low until you compare it to industry norms. If it
exceeds the average margins earned by competitors, you have a high gross margin. If your
percentage is below those norms, your small business has a low gross margin -- a low gross
profit percentage.
Variance
Gross margins vary significantly by industry, based on a variety of factors. In a purely competitive
industry, margins tend to be smaller because you have more competitors beating down their
prices to attract customers. Commodity-type products that are readily available are relatively hard
to provide with value added.
Products that are more easily customized usually offer higher margins, because you can provide
a better quality solution.
Actions
Your reaction to a relatively low gross profit percentage depends on the operations of your small
business. As the top low-cost provider in your industry, it is generally expected that you would
have lower margins. Your objective is to earn more net profits by selling greater volume than
competitors that earn higher margins. If your margin is lower than companies that offer similar or
below-par quality or value, you might need to address the issue.
Ways to optimize your revenue include increasing marketing or product development to better
emphasize your quality, and avoiding excess buying of inventory. To reduce variable costs,
negotiate better deals with suppliers, and eliminate waste in product manufacturing or acquisition.
One or both of these maneuvers can increase your gross profit percentage.
Cost Leadership and Competitive Advantage

by Ian Linton
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To gain competitive advantage, small businesses can focus on different strategies, including
leadership in cost, quality, innovation or customer service. Strongest advantage comes through
leadership in a factor that is important to customers and difficult for competitors to match. Cost
leadership means that you are the producer with the lowest costs in your chosen market sector.
That gives you the ability to set lower prices than competitors while offering customers the same
benefits.
Value
A cost leader does not have to set the lowest prices or engage in a price war, according to Fast
Company. If you have a cost advantage, you can offer customers the same product quality or the
same set of benefits at a price that matches the prices of your competitors. That represents value
to your customers. Because your company has lower costs, you can continue to make profits
while maintaining competitive prices.
Flexibility
Cost leadership also gives you flexibility if you deal with powerful buyers. If buyers demand
increased quality, higher levels of service or lower prices, you can absorb those requests without
damaging profitability, while your competitors may find it difficult to respond. That puts you in a
strong position if you operate in a market where there is little product differentiation and many
competitors. The same advantage applies if your suppliers want to raise their prices to you.
Although that will increase your costs and lower your margins, you will still be in a position to
absorb the rise.
Barriers
When you have a clear cost advantage, you can create strong barriers to market entry. New
entrants without your cost advantage would have to make a significant investment to match your
prices while maintaining profitability. This is important in markets where customers can switch
suppliers easily or where customers tend to shop around for lower prices.
Supply Chain
Supply chain collaboration can strengthen your cost advantage, according to Quality Digest. By
working with members to improve efficiency and reduce costs throughout the supply chain, you
can create a sustainable cost advantage that competitors would find difficult to match with tactical
price cuts.
Choice
When your company is the cost leader in your market sector, you have a choice of strategies.
You can set your prices at the level of your competitors and maintain profitability or lower your
prices and increase market share. Maintaining profitability gives you the opportunity to invest in
further activities to strengthen your cost advantage or implement other growth strategies, such as
developing new products or increasing your marketing budget.
What Is a Blended Gross Profit Margin?

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Gross profit margin measures the amount of money left over from revenue after the cost of goods
sold, or COGS, has been subtracted. Businesses with more than one division or product category
can report gross profit margin for each business unit separately, or they can combine the sales
and COGS from all divisions into a single gross profit number. When all divisions are combined,
the result is referred to as a "blended" gross profit margin. Understanding the distinguishing
characteristics of blended gross profit margins can help you to evaluate the profitability of all your
business models combined.
Significance
Gross profit margin takes a wide range of expenses out of the equation, including overhead,
interest and taxes. Rather than acting as a measure of company profitability, gross profit margin
specifically measures the soundness of different business models. The measure evaluates the
raw profitability of sales by subtracting inventory, direct labor and freight costs from revenue.
Thus, the blended gross profit margin measures the raw profitability of the specific combination of
business units in a company. This can provide strategic insight for growing a small business that
has multiple business units. Use the blended version of gross profit margin when you wish to
analyze the effects of changes in one business unit on the soundness of the company as a
whole.
Divisional Revenue and COGS

Adding the revenue from all divisions is the first step in calculating blended gross profit margin.
Choose a certain period for your calculations, and include all revenue from that period only.
Calculating the cost of goods sold in multiple product divisions can be simple enough: Simply add
the direct costs of all inventory sold in each division. However, adding a service division into the
mix can complicate things. Consider a company that sells computer hardware and offers a
separate tech-support service, for example. The hardware will have clear product costs, but no
inventory will be involved in the service division. Include direct labor costs and any commissions
paid to sales or service personnel in COGS for the service segments.
Other Profit Margins

Additional profit margins can provide deeper insight into the overall profitability of your business.
The operating profit margin, for example, subtracts operating expenses, such as consumable
supplies and utilities, as well as depreciation, from the gross profit margin. The net profit margin,
as another example, compares the money left over after all expenses have been accounted for to
the total sales revenue for the period, providing a final profit figure.
Profit Margin Formulas

With your total revenue and COGS in hand, use the following formula to calculate blended gross
profit margin:
(Total Combined Sales - Total Combined COGS)/Total Combined Sales
After accounting for all expenses, use the following formulas to calculate additional profit margins:
Operating margin = Operating Income / Total Sales
Net Margin = Net Income / Total Sales
How to Increase Gross Margin

by Neil Kokemuller
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Gross margin is the percentage of your revenue that remains after costs of goods sold are
subtracted. A gross profit of $10,000 on $30,000 in revenue, for instance, equals roughly 33
percent. High margins are important to covering fixed costs and earning a net profit. If your
margin is below industry averages, or on the decline, you have several options to try to improve it.
Marketing
Investing in marketing adds to your operating expenses, which can limit net earning potential in
the short run, but it can drive more traffic to your business. This helps you generate more sales
and maintain higher price points. By building up the perceived value of your brand and products
through effective marketing, you should get customers to pay premium prices or buy higher end
items without increasing your product acquisition.
Sales
Developing a more effective sales process and a talented sales force can also help you achieve
higher revenue on each sale. Selling complex, higher end solutions is generally more challenging
than selling with a low-cost emphasis. You need salespeople that ask good questions,
understand customer needs and effectively sell the value of your products and services to match.
Good salespeople avoid the temptation to negotiate on price and instead sell value and quality to
customers.
Cost Reduction
Negotiating lower costs for materials or products from your suppliers helps you lower your costs
of goods sold. If you can keep the same price points in the market, your gross profits and margins
go up. Building ongoing, trusting relationships with suppliers gives you an edge when bargaining.
You might be able to shop around and find suppliers with better rates. If you can commit to
purchasing more products at a time, your cost per item may be lowered as well.
Better Inventory Management

Improving your inventory buying can also help your gross margin. Buying inventory from suppliers
when prices are favorable helps you lower acquisition costs. Using just-in-time processes to meet
customer demand while avoiding excess inventory is also important. Stock outs equal missed
sales opportunities and alienated customers. Excess inventory leads to sales discounts and
waste, both of which negatively affect gross margins. A well-balanced inventory helps with both
variable in the gross margin equation. Lost or stolen inventory is also a problem since you have to
account for the costs of goods sold, but generate no revenue.
How to Fix Your Profit Margin

by Randolf Saint-Leger
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A company's profit is a measure of how well it executes its business strategy. Sometimes profit
doesn't measure up to expectations for a variety of reasons. This is reflected in the company's
profit margin, which is the company's net income divided by sales. The profit margin is also a
measure of the company's efficiency. Management must assess why its profit margin is below
expectations and make adjustments. To fix profit margin, the business must increase revenue,
reduce costs or do a combination of both.
Calculate Growth Rates

Step 1
Re-create your company's income statement using a spreadsheet program. Enter the line items
from your income statement for different time periods such as the current and prior year. Use a
longer time series such as a few years to better analyze the data. This allows you to identify
trends in the drivers of profit margin such as sales and operating expenses.
Step 2
Calculate the sales growth rate so you can compare your current sales to prior years' sales. For
example, if your company had sales of $1.8 million last year and $1.5 million this year, that
represents a decline of almost 17 percent. To calculate the percentage, subtract $1.5 million from
$1.8 million, divide the result by $1.8 million and multiply by 100.
Step 3
Calculate your gross profit or the difference between sales and cost of goods sold, which are the
raw materials converted to finished products for sale or inventory purchases for sale during the
period. The higher your gross profit, the more money your company keeps for itself. The gross
profit margin, another measure of operating efficiency measures your gross profit in percentage
terms by taking the difference between sales and cost of goods sold, dividing the result by sales
and multiplying by 100. For example, if sales were $1.5 million and cost of goods sold were
$900,000, your gross profit is $600,000 and your gross profit margin is 40 percent.
Step 4
Identify why sales decline from one period to the next. Lower demand, poor execution of your
company sales strategy and increased competition are examples of reasons for a decline in
sales.
Step 5
Calculate the growth rate of your cost of goods sold for the period. For example, if cost of goods
sold was $700,000 the prior year and rose to $900,000, the growth rate in cost of goods sold is
29 percent, or $900,000 less $700,000 divided by $700,000 multiplied by 100.
Step 6
Identify why cost of goods sold increased for the period relative to growth in sales. In this
example, sales declined but cost of goods sold rose. Some reasons for this could be an increase
in raw material costs and poor inventory management.
Step 7
Calculate the growth rates for individual operating expense items. These are the expenses that
your business subtracts from its gross profit to arrive at net income. Examples of operating
expense items include rent, utilities, salaries, depreciation and other day-to-day expenses of
running the business.
Step 8
Subtract total operating expenses from gross profit to arrive at net income before taxes. Subtract
taxes to arrive at net income after taxes. Calculate the growth rate for net income. For example, if
net income after taxes was $200,000 this year and was $317,000 the prior year, this represents a
decline of almost 37 percent. To arrive at the percentage decline, subtract $200,000 from
$317,000, divide the result by $317,000 and multiply by 100.
Step 9
Compare your company's profit margin with that of prior years to spot trends and any unusual up
or down movements. For example, the profit margin is 13 percent, which is $200,000 divided by
$1.5 million. This compares to a profit margin of 18 percent in the prior year, or $317,000 divided
by $1.8 million.
Making Adjustments
Step 1
Increase your revenue based on your business strategy. A low-price strategy means that you're
willing to reduce your selling price to increase revenue. If this strategy works, you should see a
pick-up in revenue assuming that your customers are price-sensitive, meaning that the main way
to get them to come back is to offer a lower price. On the opposite end of the spectrum is a high-
price strategy, where you sacrifice volume but increase the price on items for sale. You can also
adjust prices to capture different consumer segments like high-margin and low-margin goods. A
common example is a car manufacturer that produces luxury, mid-size and economy cars. The
car maker can make a higher profit margin selling luxury cars but will sell fewer of them because
of their high price tag. On the other end of the spectrum, the company will make less profit margin
off economy cars, but will be able to sell more of them since more customers can afford them.
Step 2
Identify ways to reduce costs starting with your cost of goods sold. The formula for cost of goods
sold is beginning inventory plus purchases less ending inventory. Ways you can reduce your
inventory costs include purchasing in bulk to take advantage of supplier discounts and negotiating
terms with suppliers of raw materials. Cut back on cost of goods sold to the extent that it does not
impinge on your sales.
Step 3
Identify other operating expense items that you may reduce without sacrificing the performance of
the company. Salaries are often a huge expense item. Companies often reduce staff or employee
work hours to trim this cost. However, you have to weigh the impact of a lower headcount on your
revenue. For example, there might be fewer sales people to help customers or fewer cashiers to
ring up sales, both of which might mean lost business.
How to Figure Gross Margin on a Restaurant

by M. Scilly
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The restaurant industry is not forgiving -- if you cannot make a profit, your business will not
survive. It's important, then, to keep your costs down and your revenues up. A simple measure
for keeping track of this is the gross margin. Calculate your gross margin on a regular basis and
aim to keep it as high as possible.
Revenues
Calculate your revenues by adding up your sales for the period. For instance if you had food
sales of $2,000, non-alcoholic drink sales of $1,000, and alcoholic drink sales of $1,500, your
revenues would be $4,500.
Cost of Goods Sold

Calculate the cost of goods sold for the period. This is the total cost to create the food that you
sold. To calculate the cost of goods sold, add up all of your variable costs for producing the food.
Variable costs are costs that change with production level, such as food costs, hourly wages paid
to cooks and servers, and gas used for your stoves. For example, if you used $400 worth of food,
paid hourly wages of $1,000, had gas expenses of $900, and had other variable expenses of
$200, your cost of goods sold would be $2,500.
Calculate Gross Margin

Calculate the margin by subtracting your cost of goods sold from your revenues. For instance, if
you had revenues of $4,500 and cost of goods sold of $2,500, you would have a gross margin of
$2,000. These are not profits. These earnings must first pay off your fixed costs -- costs that do
not vary by production level -- before you see any profits.
Calculate Gross Margin Percent

Gross margin may also be represented as a percentage of total sales. The gross margin
percentage is calculated by dividing the gross margin by revenues, and multiplying by 100.
Assume, for example, that a restaurant has a gross margin of $2,000 and sales of $4,500. You
would divide $2,000 by $4,500 to get 0.44. You would then multiply 0.44 by 100 to express it as
44 percent. A greater gross margin percentage is always preferable because it means that a
smaller portion of your revenues is being used to pay variable expenses.
The Three Elements of a Profit Margin

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When a business refers to its profit margin, it usually means the net profit margin. This is an
accounting tool that helps you measure your company’s operational efficiency. The higher the
margin, the greater your efficiency and profitability. Ideally, businesses want to see their profit
margins grow each year. You can calculate your profit margin in a few straightforward steps.
Revenue
Revenue refers to the total amount of sales your business makes over a given time period, such
as a month, quarter or year. To calculate profit margin accurately, your revenue figure should
exclude any discounts, returns or allowances.
Net Profit
Net profit refers to the amount of money left over after deducting cost of goods sold and business
expenses from net revenue for a given period. If the sum of cost of goods sold and expenses
exceeds revenue, net profit turns into net loss.
Percentage
A profit margin calculates the ratio of net profit to sales. A mathematical fraction is used to
determine this ratio using net profit as numerator and sales as denominator. The relationship of
profit to sales is better understood in terms of percentage. Dividing net profit by sales yields the
ratio. You can multiply the ratio by 100 to convert the figure into a percentage.
Example
As an example, a company with revenue of $100,000, cost of goods sold of $75,000 and
expenses of $20,000 would have a net profit of $5,000 ($100,000 minus $75,000 minus $20,000).
To calculate the net profit margin, divide the net profit of $5,000 by the revenue of $100,000. This
will yield .05. Multiplying .05 by 100 will show a 5% profit margin.
What Is a High-Low Profit Margin?

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Profitability and sales are two of the most important accounting elements that business managers
consider when talking about business models. High-low margin is business jargon used by
managers to refer to businesses that can operate profitably even without much sales volume.
Understanding a high-low profit margin can help you discern the relationship between profit
margin and sales turnover.
Profit Margin
Profit margin is an accounting technique used to measure the ability of a business to generate net
profit. Net profit divided by sales and multiplied by 100 will give you the net profit margin in
percentage terms. The margin shows what percentage of sales is converted into net profit.
Comparing your margin with margins of competitors in the industry allows you to measure your
profitability.
High Profit Margin

A business is said to have a high profit margin when its margin is higher than industry-average
profit margins. Industry-average margins are used as standards to know if margins of a particular
company are normal. A high profit margin is indicative of high operational efficiency and
profitability.
Sales Turnover
Sales turnover refers to the number of times the company sells its entire inventory during a given
period. The turnover rate gives you an idea of how well a company is managing its inventory. The
more goods a company is able to sell, the higher the sales turnover ratio. Dividing the total sales
for the period by average inventory in units yields the sales turnover rate. A sales turnover rate
that is above the industry-average rate is considered to be high.
High-Low Profit Margin

Business managers sometimes use the term "high-low profit margin" to express the relationship
between net profit and sales volume. The “high” in this term refers to profitability, while the “low”
refers to sales volume. A business is said to have a high-low margin when its profit margin is high
while its sales turnover is low. The term pertains to businesses that generate a high profit margin
from products that have a low sales turnover rate, such as heavy equipment manufacturers and
construction companies. Such business does not depend on high sales volume to generate
profits but is able to cover both expenses and high profits at low sales turnover.
Sales Maximization Vs. Profit Maximization

by Raul Avenir
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Maximizing profit and sales are two major concerns of business owners, but many business
managers fail to realize that sales maximization does not always mean profit maximization.
Ignorance of the features, differences and cause-and-effect relationship between these two
objectives can give you a false sense of improving profitability.
Definition and Objectives

Sales maximization refers to plans and strategies employed by a business to increase its sales or
revenues to the highest attainable level. Profit maximization refers to plans and activities involved
in the company's effort to boost net profit to the highest possible degree given the company's
current resources.
Responsible Party
The primary responsibility of a marketing or sales manager is to achieve sales targets over a
given time period. In addition to achieving sales targets, a sales manager is expected to
maximize sales to provide growth and increase profits. Profit maximization is a task that falls into
the hands of a general business manager or CEO. That person is the one who is in control of all
aspects of business operations. He must plan, organize, direct and control all business resources
to earn the highest attainable net profit.
Coverage
Sales maximization is an activity that concentrates on revenue transactions and can be
accomplished by employing various sales strategies and programs. Profit maximization entails a
more complex program of business plans and activities that does not concentrate on sales alone.
It encompasses both revenue and expenditure transactions. A business manager must increase
revenues, decrease expenses or do both to increase net profit.
Relationship
The thought that maximizing sales will help maximize profits is not always true. An increase in
sales is associated with an increase in cost of goods sold and other expenses. Profit
maximization is not achieved if marketing and overhead expenses incurred in sales maximization
exceed the gross profit generated by the additional sales.
Time Frame
Profit maximization is the long-term goal of all business owners. Business managers constantly
strive to generate the most profit over the life of a business, using all resources under their
control. Sales maximization programs can be implemented for many reasons and at various
times, but they are not done continuously. The start of a business, during lean seasons and at
times when there is excess inventory are examples of those times. Sales managers may refrain
from maximizing sales without the consent of general managers to avoid a possible shortage of
business resources such as inventory and manpower.
Revenue Maximization Vs. Profit Maximization

by Randolf Saint-Leger
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Every business faces the decision of how to maximize profit. While revenue maximization and
profit maximization may appear to be one and the same, this is not necessarily the case. Higher
revenue does not always translate into higher profit because of how a small business executes its
business and marketing strategy. A small business owner must decide the optimal business
strategy that maximizes revenue and profit.
Revenue
No matter the size of a business, revenue is important because it is the source of the business'
income stream. Businesses take different approaches to maximize revenue using various
marketing strategies as translated through their business model. A company can seek to grow
revenue by offering the lowest prices in the market. Other companies focus on offering better
products and services to differentiate themselves from the competition in hopes of maximizing
revenue. In addition, companies also attempt various pricing strategies to capture different
consumer groups, such as high-income, middle-income and low income households, in an effort
to maximize revenues.
Profit
All else being equal, a strategy to maximize revenue should lead to maximum profit. To calculate
profit, a business must subtract all of its operating expenses from its revenue. The level of these
expenses varies from business to business. A business with high revenue may produce lower
profit because of high operating expenses. On the other side of the spectrum, a company with
low revenue may produce higher profits through cost cutting and focusing on keeping low
overhead.
Operating Efficiency
The goal for a small business owner is to find the optimal strategy that maximizes revenue and
profit without having to sacrifice productivity and performance. Operating efficiency refers to how
a company manages to generate revenue and control costs. Gross profit margin, is one of
several operating efficiency ratios, calculated by subtracting cost of goods sold from revenue and
dividing the result by sales. Cost of goods sold is the expense of raw materials used to convert
them into items for sale. For example, if a company has sales of $1.2 million and had cost of
goods sold of $600,000, its gross profit margin is 50 percent. In other words, the company keeps
$0.50 for every $1 of revenue.
Profit Margin
Another operating efficiency ratio, profit margin, shows how much money the company keeps for
itself after taking into account all costs, which not only include cost of goods sold, but also rent,
depreciation, utilities and other day-to-day costs of running the business. The formula for profit
margin is net income divided by revenue. If the same company generated net income of
$350,000, its profit margin is 29 percent, or $350,000 divided by $1.2 million. This means that for
every $1 of revenue, the company retains $0.29 for itself. Profit margin allows the company to
track profitability trends.
What Is Considered a Normal Profit Margin?

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A company’s profit margin indicates how much profit the company makes for every $1 generated
through revenue or sales. The higher the profit margin in comparison to a company’s competitor,
the better for the company. What's considered a normal profit margin depends on the industry in
which the company operates.
Profit Margin Defined

Profit margin, net profit margin, net margin and net profit ratio are all terms used to measure a
company’s profitability. Profit margin is a good indicator of how a company strategizes through
pricing, product blend and cost control. Calculated as a ratio of profitability based on net income
divided by revenue, profit margin evaluates how much of every dollar in sales a company actually
retains in earnings. A higher profit margin designates a more lucrative company with better
control of costs in comparison to its competition.
Average Profit Margin

Each industry has a profit margin average, which is affected by the way a company functions
operationally, how it utilizes assets, how inventory is managed and through established cost-
control systems. A company based on more labor-intensive manufacturing will see declining profit
margins over a company using technology-driven labor. Websites such as Financial-
Projections.com provide business financial statistics, which, “may not be perfectly accurate for
your business but it does provide a great foundation for building financial statements.”
For example, the education industry sees an average gross profit of 86.56% and average net
profit of 11.61%, whereas the agricultural industry sees an average gross profit of 56.23% with
net profit averaging at 9.94%. The first step in determining an average profit margin is
researching similar companies in the industry.
Improving Profit Margins

Once the average profit margin for the desired industry is determined, businesses focus on ways
to improve profits. In general, there are two methods used to manage inventory and control costs.
One method is computing average revenue generated per employee, which divides total revenue
by the total number of employees. The other method includes minimizing the deployment of labor,
reviewing the inventory and appraising cost-management systems. Price, customer mix, product
blend and costs all directly affect a company’s profit margin.
Profit Margin vs. Markup

Profit margin and markup are often, though incorrectly, interchanged. This takes place when an
entrepreneur erroneously reports profit margins over 100 percent when in reality he is referring to
the markup of a specific product as a percentage of product cost. Net profit margin equals net
income divided by revenue, multiplied by 100, whereas net income equals all revenue minus all
costs.
Gross Profit Percentage by Industry

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Managers and investors regularly analyze various financial ratios to understand how well a
business is operating. Comparing the gross margin with average industry ratios can help identify
a company's strengths and weaknesses. Examining gross profit percentages by industry can help
a potential business owner decide the best type of business to invest in.
Top Industries
CSIMarket Inc., which provides independent market research, compared data in the fourth
quarter of 2013 on major industries in 13 sectors. Results showed the financial sector leading the
way with a whopping 86.6 gross profit percentage. The transportation sector posted an overall
62.3% gross margin while technology companies as a group posted a 56.3% gross margin for the
period.
Lowest Margins
From the same time period in 2013, the industries showing the lowest gross margin percentage
included retail at 22% and basic materials at 27%. The basic materials sector consists of
businesses engaged in the discovery and processing of raw materials, such as mining
companies.
Middle Ground
Industries posting gross margins that fell in the middle ground included consumer cyclical at 44%,
services at 34% and consumer non-cyclical at 30.7%. The consumer cyclical sector includes
businesses that provide goods and services that are considered nonessential, like luxury cars or
cruise-ship packages. Consumer non-cyclical companies provide goods and services people buy
despite economic conditions, such as beverages, personal care products and medicine.
Comparing Companies
Expenses to be paid after gross profit are figured include salaries, tax obligations and overhead,
which includes everything from advertising to utility bills and rent. These expenses vary
significantly from industry to industry. Thus, when analyzing the gross profit percentage of a
single business, a more revealing result is obtained if comparisons are limited to businesses in
the same industry or to the industry standard. For example, a manufacturing business with large
factories and warehouses has expenses much different from those of a small barbershop.
Gross and Net

Looking at net margins can provide insight into industry differences. Net margin considers
operating expenses. For instance, while the transportation sector posted a 62.3% gross margin in
the fourth quarter of 2013, it had a net margin of just 4.4%. Only the retail industry's net margin
was lower at 2.9%. These figures indicate that the transportation industry had substantial
operating costs. However, it is usually necessary to compare business trends over time as
economic and environmental factors can have drastic temporary effects on a particular industry.
What Is an "Average Profit Margin Percentage"?

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Depending on the nature of your small business, you may want to track and watch several
different profit margin calculations. An average profit margin percentage is a big-picture look at
how much you are making after paying for the products you sell. A profit percentage may be the
best calculation to find out if your results are improving or going in the wrong direction.
Profit Margin Defined

The profit margin is the portion of the selling price of a product that is greater than your wholesale
cost. If you sell something for $100 and it cost your business $80, you have a $20 profit margin.
Divide the dollar amount of profit into the selling price to get the profit margin percentage, which
in this case would be 20 percent. If you go the other direction and divide the profit by the cost --
such as $20 divided by $80 equals 25 percent -- you are calculating the markup. Markup and
profit margin are different ways of looking at the same amount of profit.
Product, Line or Overall

You can calculate and use an average profit margin percentage several ways. At the top of the
list will be the profit percentage for the total sales of your business for a specific time frame, such
as one month. Subtract the total cost of goods sold from the sales volume for your business and
then calculate the percentage. Depending on your product lineup, you also may want to calculate
different percentages for categories of products or similar products from different manufacturers.
Negotiated Prices
The average profit margin percentage becomes a very important measurement if your business
negotiates selling prices. If you let the profit percentages get too slim just to make more sales,
you business may have trouble covering expenses. On the other hand, if the average profit
percentage gets too fat, you may be missing sales that could add more gross profits to the total
but fall short of meeting the needs of price-sensitive customers. With your sales force, use the
profit percentages to let the sales staff know if they need to work to hold higher profit margins or if
they are letting too many prospects walk out the door who might have purchased with another
round of negotiation.
Increasing Your Profits

A major reason to calculate and track profit percentages is to use the information to figure out
how to increase your profits. The percentages can show you where you may be able to increase
prices or to focus on one type of product over another in your sales efforts. Also, changes in the
profit percentages can show whether your efforts are producing higher profits or you are losing
control of your pricing. With the profit margin percentages, you can compare how your business is
doing now in relation to previous results.
Deferred Gross Profit Calculations

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Accounting is a system of rules and conventions that keeps track of business assets, liabilities,
income, expenses and cash flow. It's also important to recognize revenue and associated
expenses in the period when the revenue is incurred, which poses a challenge for long-term
projects or high-priced sales made on credit. In these cases, sales are not recognized all at once,
but in installments.
Installment Sales -- Cash Method

The installment method of accounting does not recognize revenue until cash is actually received
for the product or service. Not only does the method provide a way to defer income and sales into
the following tax year, but it also provides a way to defer taxes. The alternative to the installment
method is referred to as the percentage of completion method, which recognizes revenue as the
project or sale is completed.
Gross Profit
Gross profit is the difference between sales and costs. The installment method defers gross profit
into the following accounting period until cash is collected according to the terms of the original
sales agreement. Because an installment sale is a promise of future payment, it is considered a
receivables account. That is, it is a sale on credit until cash is received.
Deferred Gross Profit Estimate

Because the project has not been completed, you will need to estimate the deferral. Use the
historical gross profit percentage as a guideline for your estimation. First, calculate the gross
profit percentage received on actual cash received. So, if you received $10,000 in cash and can
associate $2,000 in costs to the project, your gross profit is $8,000. The percentage is calculated
by dividing gross profit by the total cash received -- $8,000 divided by $10,000, or 80 percent.
Second, multiply the amount owed on the installment by this percentage for an estimate of
deferred gross profit.
Journal Entry
When cash is received, the deferred account is actualized, which triggers a debit to the deferred
gross profit account. You will not see the deferred gross profit account on the balance sheet
because it is a contra-asset account -- the balance is contained within accounts receivable. When
cash is received, debit deferred gross profit and credit realized gross profit. When you debit
deferred gross profit and credit realized gross profit, it transfers the deferral from the balance
sheet to the income statement. It is then actualized and recognized as net income.
Do Turnover Rates Affect ROE?

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Return on equity is often the most important success metric for a business; ROE tells you if the
hard work you put in and the money you risk to run your business really is paying off. Turnover
can refer to the speed of sales in relation to assets or to inventory. Two turnover ratios impact
your ROE and must be kept in check at all times.
ROE
Return on equity tells you how rapidly the funds invested in your business are growing. To
calculate ROE, divide net income after taxes by average stockholder equity, which equals
stockholder equity at the beginning of the period plus stockholder equity at the end of the period,
with the total divided by two. Assume that your laundromat earned $140,000 for the year and that
your investment in the business was $1.2 million and $1.4 million at the start and end of the year,
respectively. ROE equals $140,000/(($1,200,000 + $1,400,000)/2) = 0.1077 or 10.77 percent.
Asset Turnover
Asset turnover equals sales revenue divided by total assets. A business that took in $3 million
during the year and has $450,000 in assets has an asset turnover rate of $3,000,000/$450,000 =
6.67. If this were a supermarket with all assets invested in groceries, it would have emptied and
refilled its shelves 6.67 times during the year. If sales are profitable, the higher the asset turnover
ratio, the greater the profits and the higher the ROE. Especially if shelf or retail space is limited,
increasing asset turnover can be the best method to raise the ROE.
Inventory Turnover
Another type of turnover, inventory turnover, equals cost of goods sold divided by average
inventory. The inventory turnover ratio tells you how many times the business emptied its
warehouse. The higher this ratio, the higher the sales in relation to average inventory kept in
stock. You can raise inventory turnover either by selling more or by keeping less inventory. If
sales are profitable, both practices are good for profitability, and a higher inventory turnover ratio
boosts ROE.
Differences
The two turnover ratios measure similar aspects of a business but also have key differences.
When most of the business assets are kept in inventories, as would be the case for a dealership
selling luxury cars, for example, asset turnover and inventory turnover figures likely will be close.
However, if most assets are in real estate or machinery and equipment, with little product kept in
inventory, the ratios will differ. A restaurant owner, for example, will invest heavily into the
establishment but will have very little in inventory.
Does a Company Want High or Low Inventory Turnover?

by Zach Lazzari; Updated May 16, 2018
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Companies that have low-inventory turnover are not moving product through the marketplace
quickly. Companies that have high-inventory turnover have excellent sales, and are moving
inventory quickly. Ultimately, the turnover rate with the highest return is the best rate for any
business. Determining the best-case scenario requires knowledge of the market and of how the
market responds to the given offering.
Market Demand
Market demand has a major influence on turnover rates. High-demand products turn over quickly,
and in many cases, they maintain the expected margins, whereas low-demand products turn over
slowly. Low-demand products can still maintain great margins, and competition is often lower, as
well. A small market is not necessarily a bad market.
Understanding Low Turnover

Low turnover is not desired for products that have low margins. If a company must make a large
number of sales to turn a profit, low turnover is the worst possible result. Low turnover is perfectly
normal, and it is acceptable for specialty items that have high margins and high retail prices.
Ideally, a company will turn over the maximum number of items possible in a given market.
Selling a highly specialized medical instrument is likely to have low turnover with high profitability,
whereas selling a simple phone case accessory, will require a high turnover rate on tight,
competitive margins to make a profit.
Downsides of High Turnover

Typically, high turnover rates are a healthy sign of a strong market, and are a great sales
strategy. However, high turnover does have a dark side. Reducing prices to the point that the
margins are extremely low, which is designed to drive higher turnover rates, will negatively affect
the market as a whole. Competitors may be forced to reduce their rates, and the market will
become conditioned to the lower rates. Ultimately, high turnover, at little to no margin, is not good
for anyone, except the consumer. Eventually, the negative effects may even reach the consumer,
as businesses reduce manufacturing quality to remain solvent, and to stay above water.
The Ideal Formula

The ideal turnover rate returns the highest profit margin. A company that's maximizing turnover
rates without sacrificing its margins is growing and driving revenue. A company with high turnover
and ever-decreasing margins is not sustainable. A company with low-turnover rates and low-
margins is not a great scenario, either. Strive for high-turnover at a high-profit margin, with a
sustainable business model to maximize long-term viability and profitability.
Retail Method for Gross Margin Calculations

by William Adkins
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When you run a retail business, closely monitoring costs relative to sales is essential to
profitability. Gross margin allows you to track how much money you have to pay in operating
expenses and allow for making a profit. In turn, this helps prevent unpleasant surprises when it
comes time to figure your business’s profitability.
Description
Gross margin, or gross profit margin, is the difference between the cost of goods and net sales.
Net sales are the dollars actually received for the goods sold. Don’t confuse gross margin with
markup. A retail markup is a percentage of the cost of goods that is added to the cost of goods to
determine a retail price. Typically, businesses calculate gross margin for the entire retail
operation, but it’s sometimes useful to figure gross margin for product categories and specific
products in order to assess their profitability compared to other goods offered for sale .
Cost of Goods
Before you can calculate gross margin, you must determine your cost of goods. In a retail
business, it is the total expense required to acquire you inventory. Retail cost of goods normally
includes the price paid for inventory plus allowances for losses due to breakage or spoilage. For
example, if you pay $40 for a particular item, you might add $1 for allowances, giving you a total
cost for the item of $41.
Calculating Gross Margin

Determine net sales by subtracting returns from your gross receipts. Then subtract the cost of
goods from net sales. The result is the dollar amount of your gross profit margin. Convert the
dollar amount to gross margin percentage by dividing the gross margin in dollars by the net sales,
and then multiply the result by 100. For instance, if net sales total $2,000 and your cost of goods
is equal to $1,400, your gross margin is $600. Dividing $600 by $2,000 works out to a 30-percent
gross margin percentage.
Significance
Gross margin is useful for assessing the impact of discounts and changes in the cost of goods on
your potential profit. It also allows you to determine if prices are high enough to cover cost of
goods plus operating expenses, and still leave room for profit. Gross margin also serves as the
basis for calculating net profit margin. Net profit margin is your gross profit margin minus
operating expenses. The net profit margin serves as a measure of operating efficiency, meaning
how well you are controlling operating costs in your business.
How to Add a Markup Percent to a Product

by Kevin Johnston
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If you sell products that you don’t manufacture, you make a living by selling them for more than
you bought them for. This means you must add a “markup” to the cost of the item. Though this
sounds simple, choosing how much markup to add can mean the difference between success
and failure for your business.
Percentage of Cost
The term “markup” refers to a percentage of the cost of an item. For example, if an item costs you
$100 and you mark it up 20 percent, the price you will sell it for is $120. That is because 20
percent of 100 equals 20, and 20 plus 100 equals 120. The way you speak or write about this is
to say that you have a 20 percent markup on that product.
Choosing the Markup

You can’t randomly choose a percentage you will mark up your products. You must take into
account what your competition charges for similar products, the cost of your overhead, wages
you pay and the amount of profit you want. To arrive at the markup, you have to work backward
from what you need to make. For example, if you buy a product for $100 and need to make at
least $40 on it to pay your expenses, divide your markup amount, 40, by your cost, 100. You
need a 40 percent markup on your product to succeed.
Profit Margin
Don’t confuse markup with profit margin. Lenders, vendors and other stakeholders in your
company may ask what your profit margin is. Keep these differences in mind between markup
and margin. Markup is a percentage of cost. Margin is a percentage of the selling price. For
example, your $140 item that cost you $100 has $40 added to it. The markup is 40 percent.
Because you sold it for $140 and made $40 in profit, divide your profit, 40, by the selling price,
140. You find in this case that you have a 28.5 percent profit margin, because 40 divided by 140
equals .285. Multiply by 100 to get the percentage, which is 28.5 percent. If all your products
were priced in the same way, you could say your business operates on a 28.5 percent profit
margin, meaning you make 28.5 percent on everything you sell.
Discounts
When you offer a discount, you take a percentage off the selling price. This percentage tells the
customer how much she saves when buying the product. You could discount your $140 item by
10 percent. Ten percent of 140 is 14, so you would take off $14 and sell the product for $126.
Your new markup would be 26 percent, because you made $26 on a $100 item, and 26 divided
by 100 equals 26. Your profit margin, however would be the $26 you made divided by the selling
price of $126, which equals 20 percent.
What Does Decreasing Inventory Turnover Mean?

by Elliott Taylor; Updated April 20, 2018
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Inventory turnover is one measure of a company's performance and financial health. Low
inventory turnovers generally mean a company is holding too much inventory compared to its
sales. Decreasing inventory turnover often means sales are decreasing below expected levels,
although that is not always the case. Looking at the company's complete financial statements for
several periods will help identify whether the decrease in inventory turns is temporary or indicates
a long-term problem.
Calculating Turnover
The inventory turnover ratio is calculated by dividing the cost of goods sold for the period by the
average inventory for the period. For instance, if cost of goods sold was $10,000 for the quarter
and average inventory was $5,000, then $10,000 divided by $5,000 would equal an inventory
turnover ratio of 2. Two inventories per quarter means a company takes one and one-half months
to use and replenish on-hand inventory
Significance of the Numbers

Generally, higher inventory turns equate to higher sales, especially when compared to a
competitor in the same market. Inventory turns are also an indicator of how well a company is
matching its inventory levels to support its sales. Properly planning production means the
company has neither too much or too little inventory on hand.
In a perfect world, a business would end each day with zero inventory by producing exactly what
was demanded by the customer each day. Inventory turns have an impact on liquidity, since
lower turns mean that more of a company's money is tied up in inventory. Slower-moving
inventory increases risk to the company. As inventory ages, the risk of inventory loss, damage or
expiration increases.
Causes of Decreasing Turnover

The most common cause of decreasing inventory turnover is a decrease in sales. When a
company has planned and produced a certain level of inventory based on sales forecasts that
don't materialize, extra inventory is the result. Decreasing turnover can also be the result of
returns from a prior period, extra production to create safety stock against future potential sales
increases or fulfillment of a contractual stocking agreement with a customer.
Special Circumstances
In some cases, a high inventory turnover ratio may not indicate that a company is doing well. It
may mean that the company is actually running too low on inventory and losing sales as a result
of stock-outs or lengthy lead times. Inventory turns can be artificially inflated for one period based
on advance sales or a significantly discounted price. For instance, a clothing brand selling last
year's designs for a fraction of their original price may see increased inventory turns but falling
profits. This is why it's important to look at several sequential periods of the company's financial
statements to understand its true health.
Accounting Cycle vs. Operating Cycle

by Kathy Adams McIntosh
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Business managers and employees experience a variety of cycles throughout the course of
business. The economy cycles through periods of recession and growth. Sales fluctuate based
on seasons. Internally, the company’s management works through the accounting cycle and the
operating cycle. Each of these cycles involve different aspects of the business and require
management to consider various actions. Understanding how these two cycles differ and overlap
gives management the knowledge to use this information to make decisions.
Accounting Cycle
The accounting cycle revolves around recognizing financial transactions and reporting the results.
The accounting cycle follows several steps. These include recording financial transactions,
creating preliminary financial statements, recording financial adjustments, creating final financial
statements, and recording closing entries. The accounting cycle begins on the first day of the
period and ends when the final closing entries are completed. At the conclusion of the accounting
cycle, a new period is started and the cycle begins again.
Operating Cycle
The operating cycle revolves around the payment of cash and the receipt of cash. The steps of
the operating cycle include purchasing merchandise, selling the merchandise, billing the
customers, and receiving payment from the customers. The operating cycle begins when the
company orders the merchandise and ends when the company receives payments from its
customers. The operating cycle continues indefinitely without a defined beginning or end. With
each new purchase, a new operating cycle begins.
Overlaps
Several aspects in the accounting cycle and the operating cycle overlap. Each transaction that
occurs in the operating cycle becomes an entry in the financial records within the accounting
cycle. These transactions include inventory receipts, cash payments or customer collections. The
accountant receives documentation of each transaction and enters it into the financial records. At
the end of the period, the accountant reports the financial results of all the transactions that
occurred.
Differences
While the same transactions impact both the accounting cycle and the operating cycle, there are
some significant differences. The accounting cycle has a defined beginning and end. All
transactions must occur within the accounting cycle to be reported for that accounting period. The
operating cycle is a continuous process. The accounting cycle is based on the timing of different
activities and records all transactions that occur within the timeframe of that period. The operating
cycle is based on cash transactions. Each operating cycle begins when the company pays cash
for its inventory purchase and ends when it receives cash from the customer.
Revenue Vs. Profit

by Neil Kokemuller
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Revenue and profit are often used synonymously, but they mean quite different things in a
general business sense and from an accounting perspective. Revenue, or sales, is the money
brought into the company through sales of products and services. Profit is actual earnings after
you subtract expenses from revenue.
Revenue Basics
Revenue is generated on each sale of a product or service. Some sales are paid immediately
with cash, while others are paid on account, in some businesses. Payments on account are
recorded as accounts receivable and the payments are collected later on. In an accrual
accounting system, you record revenue at the time that it is earned, not when payment is
collected. Revenue appears at the top of your company's income statement, and the balance
sheet lists the current amount of accounts receivable under current assets.
Generating Revenue
In the long run, for-profit companies want to earn profits. Sometimes, companies sacrifice short-
term profits, though, to drive revenue growth. Creating cash flow, getting rid of extra inventory
and building up a customer base are common reasons to focus on revenue versus profits. Sales
promotions or discounts are common tools used to induce customers to make purchases. These
discounts normally mean you sell products or services near or below what you paid for them.
Profit Basics
Profits represent the earnings of your business for a given period. If your company had a profit of
$50,000 during the first quarter, that means your business earned $50,000. Having profit doesn't
necessarily mean you have money. Often, your company's profit for a period is higher than your
cash flow generated. This is because products sold on account are often recorded before you
collect account payments.
Levels of Profit
Your income statement actually includes three basic profit numbers in dollars: gross profit,
operating profit and net profit, in that order. Gross profit is the first section on the statement and it
shows your revenue in the period minus your costs of goods sold. Operating profit is your gross
profit minus fixed costs like rent, utilities and labor. Your net profit for the period is the final
number on the statement. It equals operating profit minus irregular expenses and plus irregular
revenue. Legal fees to settle a lawsuit are an example of an unusual, one-time expense.
Revenue on a building sale is an unusual one-time revenue.
https://yourbusiness.azcentral.com/revenue-vs-profit-1647.html
The Ratio of Gross Revenue to Advertising

by Raul Avenir
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Among all business expenses, advertising has the greatest impact on sales. Properly managed, it
can increase revenues and maximize sales. Some business owners spend funds on advertising
without actually knowing how to measure its effectiveness. The gross revenue-to-advertising ratio
or advertising-to-sales ratio allows you to gauge the effectiveness of such expenditures in
improving your sales levels.
Definition
Advertising-to-sales ratio is a financial analysis tool designed to measure the efficiency of
advertising expenses in generating sales. It measures what percentage of gross sales is spent on
advertising expenses. Comparing this ratio against industry-average ratios allows you to see
whether your expenditure is higher or lower than normal levels. Comparing the ratio against your
past ratios allows you to measure the results of advertising campaigns.
Calculation
Dividing advertising expenses by gross sales for a given period yields this ratio. Multiplying the
ratio by 100 expresses it in percentage terms. Gross sales is used instead of net sales, because
advertising affects all sales regardless of whether or not the merchandise was returned and
because sales returns are an after-sales transaction.
Example
As an example, assume that ABC Company’s income statement at the end of a given month
shows gross sales of $1 million and an advertising expense of $50,000. Dividing the period’s
advertising expense of $50,000 by gross sales of $1 million gives an advertising-to-sales ratio of
0.05. Multiplying the ratio by 100 gives you 5 percent. This means that 5 percent of gross sales
was spent on advertising expenses.
Indications
The lower the ratio is, the more efficient you are in using your advertising budget. A ratio that is
lower than the industry-average advertising-to-sales ratio indicates you are more efficient in using
your budget than most competitors in the industry. A high advertising-to-sales ratio may indicate
that high advertising expenses resulted in low sales revenue.
What Are the Benefits of Making a Profit?

by Neil Kokemuller
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While making a profit is a simple and common objective for any for-profit business, company
leaders surprisingly sometimes take their eyes off this goal. Profit is distinct from revenue. You
can lower prices or invest heavily to generate revenue, but if your costs are too high, you don't
make profit. Earning a bottom-line profit provides several major benefits.
Retained Earnings
The most direct tangible advantage of earning profit is that you have a chance to retain earnings
and increase your equity position. In accounting, retained earnings is your accumulated net profit
over time. In essence, if your company makes money, it increases its financial position and
company value. Without profit, you may eat away your cash reserves and make your company
less attractive to potential investors, creditors and partners.
Owner Income
Business profit is the equivalent of income for owners. In small businesses, owners often take a
draw or share of income in the form of periodic distributions or dividends. For sole proprietors or
partners in a small company, company profit may provide a sole or primary source of income that
owners rely on to provide for themselves and their families. If the company doesn't make money,
owners may go into debt or have to find other employment.
Business Growth
Companies often use profit to invest in business growth. This is usually a contrasting way to use
retained earnings as opposed to paying dividends. With profit, you can invest in new buildings,
equipment, labor, supplies and technology infrastructure. This can create a domino affect, leading
to more profit in the future. Additionally, profitability makes your business more appealing to
banks and creditors, which gives you possible access to loan funds for growth.
Company Morale
An indirect benefit of making money is that it positively impacts company morale. Owners
naturally feel better about their time, energy and monetary investment in operating the business.
Employees may also take pride in knowing they work for a profitable, successful company.
Additionally, profit allows a company to operate with a more employee-friendly approach
regarding strong compensation and resource provision. This can instill greater faith and a sense
of security in workers.
How to Set a Profit Margin

by Devra Gartenstein
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Small businesses are founded on core principles and numerical relationships that determine their
financial viability. However, every small business is unique, and formulas that work for one
business don't necessarily work for another even when they represent widely accepted industry
standards. Setting a profit margin is a matter of researching conventions and industry objectives,
and then tailoring these numbers to your company's specific circumstances. But the process of
setting a profit margin is also empirical and ongoing, and every business owner must regularly
evaluate whether the profit margins he has set are sufficient to cover his business and personal
expenses.
Step 1
Project all of the direct costs your business will incur to operate at a level that your anticipated
infrastructure can realistically maintain. For example, if you are opening a bagel bakery that will
be able to produce 5,000 bagels per day, calculate the labor and materials costs for producing
this number of bagels.
Step 2
Research direct operating cost standards for your industry. There is no single source that
contains these numbers for all industries, but this information can usually be found in industry-
specific manuals and textbooks. For example, restaurateurs usually aim for ingredients costs and
payroll costs of about one-third of gross revenue.
Step 3
Set a price for your product based on your direct operating costs and the percentage margins
specific to your industry. For example, if it costs $1,000 in ingredients and $1,000 in labor to
produce 5,000 bagels, set the price at $3,000, or 60 cents per bagel, a price that will allow you to
maintain the industry average 33 percent each for food and labor costs.
Step 4
Calculate the amount of product that you expect your business to produce and sell each month
based on your production capacity and the demand you have observed through your marketing
research. Using the price you have determined based on your industry average, calculate how
much capital you will have left over each month for fixed operating expenses such as rent. Add
the projected cost of these fixed expenses to the projected cost of your variable expenses to
project your total expenses. Subtract your total projected expenses from your total projected
revenue to calculate projected net profit. Divide this projected net profit by your projected gross
revenue to calculate your projected profit margin.
Step 5
Evaluate your profit margin over time to determine whether your projections are realistic and
whether the margin you have set is sufficient to cover your business and personal expenses. A
profit margin goal that you rarely attain is most likely unrealistic and a profit margin that does not
provide enough income for you to pay yourself is most likely insufficient.
Profit Margin for Handmade Jewelry

by Valerie Bolden-Barrett
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Profit margin is a measure of how well your jewelry business is doing. To calculate profit margin,
subtract your costs from your sales, or gross income; the result is net income. Divide net income
by gross income and multiply that figure by 100 percent; the result is profit margin. To raise the
margin, you must keep your business costs low and price your jewelry so that it’s profitable.
Labor Costs
Making jewelry is labor intensive, even for the most skilled crafter. Your collection likely includes
one-of-a-kind pieces. Factor into your price the time you spend designing and assembling each
piece. Set your price to reflect your skill as a jewelry maker.
Lower your labor costs and raise your profit margin by speeding up your production time. Your
potential sales volume increases with faster production. Jewelry makers typically pick up speed
with experience.
Material Costs
Set prices that cover the cost of materials and labor to raise your profit margin. The range of
materials for making jewelry is broad and so are the costs. Base your prices on whether you use
precious metals, for example, versus base metals for earring hooks and clasps. Use the same
strategy if you prefer low-cost acrylic parts over semiprecious stones for beadwork. Set
appropriate prices for environmentally inspired jewelry; even no-cost recycled materials have
greater value when crafted into jewelry.
Tools also range in variety and cost. Decide whether you need a high-quality stainless steel wire
cutter with thick padded handles for your work or if a lower-priced, good-quality cutter would
suffice and keep down expenses.
Location Costs
Where and how you sell your handmade jewelry can raise or lower your profit margin. A business
website with a reasonable monthly fee might be an economical way to showcase your handmade
jewelry. Commercial selling or bidding websites can post your jewelry for a nominal fee.
Renting a brick-and-mortar space allows customers to see your work up close. Instead of renting
space, however, you might offer retailers a commission to sell your jewelry in their shops.
Jewelry is a popular-selling item at craft fairs. Local events sometimes are free. Others charge
application/booth fees of up to $500 for a two-day event. Craft-fair expenses also include travel
and set-up time. Determine whether craft fairs can generate enough sales to cover your costs
and raise your profit margin.
Marketing Costs
Finding cost-effective ways to market and promote your jewelry business can raise your profit
margin. Using email advertising instead of buying costly newspaper ads is a no-cost promotional
strategy. Blogging on fashion and jewelry websites is another. Participating in business expos
and other community-based events are low-cost ways to promote your jewelry.
Selling Prices
Craftspeople often have trouble setting prices for their goods because they don’t know what their
creative work is worth. They often underprice their jewelry to keep from scaring off customers.
They reduce prices when their pieces aren’t selling, or when they’re financially strapped and
eager for a sale. Consider pricing your jewelry by the “cost of goods sold” or the “what customers
are willing to pay” methods. Under “cost of goods sold," you mark up your jewelry by a
percentage of the cost of materials and labor. With the "what customers are willing to pay”
method, your profit margin is likely to be higher if your customers believe your work is worth the
asking price.
What Causes the Decline in Gross Profit Margin?
by Georgann Yara; Updated April 30, 2018
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While it's just one component in analyzing your business's overall health, the gross profit margin
will help you understand how much you are spending on the products or services you sell. It's
also a tool to use to set prices and observe the viability of a particular product or service. The
greater your margin, the more money you are retaining that can be used in other areas of your
company. However, there are several reasons for a shrinking margin.
What Is a Gross Profit Margin?

A gross profit margin is a ratio that measures how much money you have remaining from the sale
of an item or service after subtracting all the costs involved to produce the item or service. For
example, if a product or service generated $100,000 in sales last year and it cost you $80,000 to
make that product or complete that service, your margin would be 20 percent. Typical gross
margins are usually around 10 to 15 percent. The lower your gross margin, the more you have to
sell to see any sizable profit.
Result of Growth
Believe it or not, your gross profit margin could be at its largest when your business is just starting
out. You've got a small staff, low overhead and a conservative product or services lineup. In the
service and manufacturing industries, in particular, profit margins decrease when sales increase.
These businesses could see a 40 percent margin until they hit around $300,000 in annual sales,
about the time when they start hiring more people. Growth and success typically lead to bigger
facilities, upgrading or increasing equipment and expanding your products and services. All of
these factors contribute to a declining margin, despite an increase in sales.
The Wrong Pricing

Not implementing prices that maximize profit on each sale is a common downfall of businesses
that appear to be thriving on the outside but are financially deteriorating inside. Your bakery may
offer the best custom cake deals in town, but if your pricing doesn't accurately account for the
labor, ingredient and customer-service costs involved with each cake, your profit margin will
suffer. When that national chain coffee shop opens up across the street from your mom-and-pop
cafe, it's tempting to lower prices to lure customers. But this is not a sustainable strategy, and it
makes it nearly impossible to raise your prices later if you must.
Cost of Materials
When the price of concrete, flour or gas increases so do your expenses, bringing your profit
margin down. If the shellfish special that customers went crazy for last year isn't selling and
you're forced you to toss out shrimp, mussels and crab meat daily, that will also show up in your
bottom line.
Labor Pay
Giving employees a 2 percent raise may not seem like a huge game-changer, but it's enough to
move the profit margin needle. A large order that required most of your staff to work overtime to
fill it by deadline or a series of events that required you to pay out more shift differentials at your
diner are other causes of increased labor costs that will have an impact on your profit margin
Consumer Trends
You can't control when an increase in health awareness brings fewer customers to your fast-food
burger joint or decreased demand for landscape photos and portraits takes its toll on your
photography business. But you can add grilled chicken sandwiches and fresh vegetable options
to your menu or shift your business model to wedding and special events photography.
Tip
 Consider these ideas for boosting your gross profit margin:
Increase prices: It's not as scary as it sounds and can work in your favor. Instead of settling for
matching competitors' prices, research what they offer and provide something better, such as
higher-end products or services that attract a "boutique" customer. Better products justify higher
prices.
Reduce cost of goods: Negotiate with suppliers for better deals on items you sell. See about
purchasing products in bulk or ask about cash or early payment discounts.
Reduce waste: Advance planning can help you manage inventory more efficiently and reduce
surplus inventory that would otherwise spoil or get tossed.
Mix it up: If you sell many different products or services, determine which ones offer the highest
gross profit margins, and streamline your mix of offerings to accommodate those or eliminate the
ones that are most costly.
Add something new: If you sell only a few types of products or services, think about adding new
ones that will complement your business and have the potential to bring in new customers and
generate more revenue.
Be diligent: As your business grows, continue to tend to its profit margins. Larger sales numbers
are impressive and important, but make sure you're making maximum money and efficiency on
those sales.
Contribution Margin Vs. Gross Profit

by Hunkar Ozyasar
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Many business owners get so caught up in increasing sales that they lose track of how profitable
those additional sales actually are. It may not be easy to guesstimate how your sales proceeds
will trickle down into your bottom line, especially when you heavily discount your products, or
throw in perks such as free shipping or extended warranties. This is where gross margin and
contribution margin come in.
Gross Profit
Gross profit equals net sales minus the cost of goods sold, and it is the lifeblood of any business,
large or small. In this formula, net sales equal gross sales minus sales discounts and returns. The
cost of goods sold equals the total amount of money directly spent to manufacture and deliver the
goods, or to deliver services. The cost of goods sold excludes indirect expenses, also known as
overhead costs, such as advertising, taxes, and research and development costs. Overhead
costs are later deducted from gross profit to arrive at net income. Since every firm has overhead
costs, net income is always a smaller number than gross profit. In short, a company that isn't
making enough in gross profit won't be able to pay its bills, and therefore can not long survive.
Gross Margin
Gross margin represents the percentage of net sales that the firm takes in as gross profit. It
equals gross profit divided by net sales. If you have sold $500,000 worth of product, and the cost
of goods sold is $300,000, the gross profit is $200,000. The gross margin is $200,000 divided by
$500,000 which equals 40 percent. A business should not focus on gross margin exclusively,
since you can increase gross margin but end up with less in gross profits. If your gross profits
drop to $170,000 and sales decline to $400,000, gross margin would be higher, at 42.5 percent,
yet gross profits would be $30,000 lower.
Contribution Margin
Contribution margin is a more relevant measure to assess the profitability of additional products
sold, and only takes into account variable costs. Contribution margin equals net sales minus
variable product costs and variable period expenses. In simpler terms, you deduct all expenses
from sales that directly increase when volume is scaled up. The rent you pay for your factory is
factored into gross profits, for example, but since the rent doesn't increase when you produce
more, it isn't a variable cost, and therefore is not considered when you calculate the contribution
margin. Similarly, the gasoline used to deliver products to retailers is a variable expense, while
the insurance of the trucks is not.
Relevance
The gross profit gives you an excellent sense of a company's big picture, and tells you if its
overall pricing strategy makes sense. If gross profit is insufficient, you should consider raising
prices, lowering production costs, or both. The contribution margin tells you how you should
evaluate incremental sales. If, for example, the contribution margin is $400,000 and you sold
100,000 T-shirts, each T-shirt contributed $4 to gross profits after all variable costs are deducted.
An additional order of 100 T-shirts will bring in $400, and is not worth it if the hassle involved does
not justify this income. When you must offer a very competitive price or thrown-in extras to get the
business, contribution margin is a highly useful measure of effectiveness.
Trends in Managerial Accounting

by John Freedman
RELATED ARTICLES

 Direct Sales Model Advantages
Trend analysis, the examination of business metrics over the course of time, is popular in
managerial accounting. By looking at numeric trends, small-business owners can assess
business performance and look at ways to make the business better. Understanding some of the
most common trend analysis metrics in managerial accounting can help you look at the some of
trends in your company and make data-driven decisions to improve your business.
Sales
Many small businesses analyze their sales trends. In most cases, managers are looking for a
positive trend in sales over the prior year. However, this may not be that informative. For
example, if the general economy is poor, even the most successful companies may be
experiencing reductions in sales. In this case, positive sales growth may not be a realistic goal.
On the other hand, if the economy is doing well, the best companies may be enjoying large levels
of sales growth. In this case, positive sales growth may be misinterpreted as successfully
capturing potential sales, when this may not be completely the case.
Costs of Goods Sold

Both merchandising and manufacturing companies often track trends in the company's cost of
goods sold. For merchandising companies that have a stable mix of products sold, increases in
cost of goods sold can signal paying higher prices for items that will be resold or a problem with
inventory management, such as shrink. Shrink is a term for inventory that you can't account for
during an inventory count. The usual assumption is that someone either outside or within the
company has stolen this inventory. For manufacturing companies, trends in cost of goods sold
can be more difficult to analyze. Increasing manufacturing costs could be related to increasing
materials, labor or overhead costs or excess usage of these items.
Net Income
Parties both internal and external to the business often examine profitability trends. However,
profitability in a small business is usually looked at differently than that of large publicly traded
companies. While large companies often express profitability in terms of meeting or beating
analyst forecasts of earnings per share, small businesses often are more concerned with
maintaining a trend of increasingly profitable accounting periods. Other owners seek a stable and
predictable pattern of profits. However, in almost all cases, small-business owners seek to make
a profit each year.
Conversion
Especially common in retail companies, conversion is the ability of a company to make a sale to
someone who visits a retail location. For example, if 10 people came into your store and you were
able to make a sale to five of these potential customers, your conversion rate would be 50
percent. Companies often track trends in conversion to assess the effectiveness of sales staff. In
addition, conversion metrics can provide additional information to explain changes in sales. For
example, if the sales trend is decreasing with the conversion trend, then sales decreases are
unlikely to be fully explained by reductions in people shopping at the store but might be better
explained by an ineffective sales staff.
Costing for the Fashion Industry

by Victoria Duff
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It might look easy to design a clothing line, sell it to retail stores and watch happy consumers buy
everything you produce. However, if you don't control your costs, based on what you know the
consumer will pay for your clothing, your line might end up too expensive or provide too little profit
to fund your creation of next season's line. Start with researching retail prices in your target
market, wholesale prices and manufacturing costs before you begin designing.
Know Your Costs

Fashion designers producing for the retail marketplace, rather than custom or couture, know that
their direct costs, such as raw materials and manufacturing, plus their indirect costs, such as
financing, marketing and administrative costs, must add up to a number that allows them to make
at least 10 to 20 percent profit on their wholesale price. The wholesale price must also be low
enough for the retailer to make a profit on the price the customer is willing to pay. Then they
design their lines to meet those cost requirements.
Retail Mark-Ups
If you create a shirt design you expect will sell in a store for $40, the wholesale price will have to
be no more than $20 per shirt. Keystone, or standard retail markup, is 50 percent of the expected
retail price, which is double the wholesale price. It might be higher or lower depending on the type
of clothing and store, but since this is an important part of your costing, check the practices in
your target market. If you are a start-up or small designer, you might be selling directly to the
customer or to boutiques, without a wholesaler. This practice can cause problems later if you
decide to expand your business reach by distributing through wholesalers. Either the retail price
will rise or your profits will suffer when the cost of the wholesaler is added.
Wholesale Mark-Ups
Wholesale reps can add anywhere from a 10 percent commission on sales to a wholesale
markup of double your unit price. So if your retailer is buying your shirt at $20, the wholesaler
might pay you $10 for the shirt. Out of that $10, your cost of design, manufacture, shipping and
business overhead should total approximately $8 per shirt to leave you with a 20 percent profit.
Figure that for every $2 of retail price, your cost should not exceed $0.50 per unit. If you are
dealing in volume exceeding 15,000 units, you might qualify for discounts to help your profit
margin.
Manufacturing Costs
Manufacturing includes pattern making, the cost of the textiles, cutting, sewing, finishing details,
labels, tags, hangers and protective bags. Learning about the individual manufacturing costs
helps you control the cost of producing your garment by altering the design or choosing different
textiles and finishings, such as decorations, buttons, fasteners, zippers and belts.
Delivery Pricing
If you are wholesaling garments bought from an overseas manufacturer or designing garments to
be produced by a manufacturer, the manufacturer will give you a price per unit, free on board,
which means delivery to a port is included in the price. Landed duty paid is another popular unit
price quote, which includes delivery to a port and all costs of customs and taxes. When you
obtain quotes from offshore manufacturers, make sure you understand what the quote includes.
How to Increase Bakery Profits
by Katie Jensen
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Bakery profits begin with revenues, or sales, from your muffins, cookies, cakes and breads.
Expenses directly related to production of the baked goods are known as cost of goods sold and
subtracted from revenues to determine the gross margin. Administrative, general and marketing
costs are subtracted from the gross margin, as are depreciation and amortization, to arrive at net
profits. Increase profits by increasing revenues or decreasing expenses to get your share of a
retail bakery market valued at $3 billion at the time of publication, according to the Center for
Economic Vitality.
Additional Products
Add additional products to your baked goods to boost sales. Customers are more likely to buy
additional loaves of bread if you offer both rye and whole wheat for example. Other products
might include a line of gluten-free cupcakes in addition to the cupcakes you make with wheat
flour. Offer supplemental products, such as juices and coffee in the morning or light salads and
soups at lunch, to increase sales.
New Markets
Review your current customer base and analyze your competitors to determine a gap in the
market you could fill. An example would be to offer wedding cakes by marketing through florists,
bridal shops or bridal trade shows. If you have a bricks-and-mortar shop, consider lining up
restaurants or gourmet grocery stores to offer your baked goods to their customers.
Different Distribution
Get your cookies to the customer using several different methods of distribution. Establish an
online presence through a website, blog or social media site. Customers order baked goods from
the site for delivery to themselves or as gifts. For example, put together a Mother's Day cake
sampler, a holiday breakfast basket or a box of cookies for students at college.
Decrease Ingredient Expenses

Analyze your ingredients and where you buy them. Butter, eggs, cream, flavorings and flour are
all necessary ingredients for your baked goods. Buying a gross of eggs from a wholesale vendor
is less expensive than buying 12 dozen eggs at the grocery store as long as you have the space
for storage. Perishable goods such as butter, milk and eggs require refrigeration. Flour, sugar and
other dry ingredients must be kept in secure containers safe from moisture and insects. You may
have to increase expenses for additional refrigerators and containers to decrease ingredient
expenses in the future.
Decrease Operating Expenses

Look at each of your operating expenses, including staffing. If it's time to renew your lease, talk to
other tenants in the area to see if your lease is in line with theirs. Do the same for insurance and
utilities. Track your advertising expenses to see which programs are effective and which aren't
producing. For example, you might offer a coupon in a magazine and then track how many
coupons are redeemed
Why Does Revenue Increase When the Gross Profit

Margin Decreases?
by Neil Kokemuller; Updated April 13, 2018
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Gross profit margin equals your income statement's gross profit divided by revenue for the period.
It is a way to measure how efficiently you turn revenue into profits. Gross profit is the difference
between your revenue and costs of goods sold. If your revenue goes up, your gross profit and,
therefore, your margin should theoretically increase. However, this isn't always the case.
Quality Improvements
Your revenue increase may result from an investment in higher quality products. This means that
at the same time your market prices and revenue go up, your cost basis on products goes up as
well, mitigating the revenue increase effect. Over time, you want to increase the overall value of
your solution so that customers pay more for quality improvements than you have to invest in
acquiring better quality products.
Inflation
If your revenue increases at a proportion less than your variable costs, your gross margin
decreases. As an example, assume you had $100,000 in revenue, a gross profit of $50,000 and a
margin of 50 percent in one period. The next period, your marketing efforts pay off and you attract
more customers. This drives revenue up to $150,000. A similar proportionate increase in gross
profits would equal $75,000, maintaining the 50 percent margin. However, even basic cost
inflation on your supplies that push your variable costs slightly higher would reduce your gross
profit amount and thereby reduce your margin.
Sales Promotions
Your revenue increase may result from significant discounts on your products, which attracts
more customers but reduces your margins. If you sell 1,000 products at $10 per piece in a
quarter, you generate $10,000 in revenue. Variable costs of $6 per item, or $6,000 total, leaves
you with $4,000 in gross profit and a 40 percent margin. The next quarter, you offer customers a
10 percent discount to grow your customer base. The effort succeeds in attracting new customers
and you sell 1,200 products at $9 per item. This gets you $10,800 in revenue. Your variable costs
for 1,200 products at $6 equals $7,200. The resulting gross profit is $3,600. This is a 33 1/3
percent gross margin, which is almost 7 percent lower. You gained new customers and achieved
higher revenue but your discounted prices lowered margins.
Change in Inventory Accounting

In general, companies use one of two approaches to account for inventory as it is sold: last in first
out, or LIFO, or first in first out, or FIFO. With LIFO, you record the variable costs for the most
recently acquired products first as you sell items. With FIFO, you record the cost of goods sold of
the first acquired inventory first. Revenue is not impacted by your decision. However, if you switch
from FIFO to LIFO between periods, your costs of goods sold go up more significantly than your
revenue during normal inflationary conditions where costs go up over time. This is because with
LIFO, the most recently acquired items usually have the highest cost basis. Thus, you could
increase revenue, but switching to LIFO could increase costs of goods sold at a higher rate, thus
decreasing gross margin.
Gross Profit Margin in Food Industry

by Brian Hill
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While the food industry covers agriculture, food processors, retail stores and restaurants, the
calculation for gross profit margin remains the same -- revenues minus cost of goods sold. Cost
of goods sold is the beginning inventory plus purchases minus ending inventory. For example, the
company has $50,000 of beginning inventory, purchased $100,000 and has an ending inventory
of $25,000. Cost of goods sold is $125,000. If sales were $325,000 for that same period, the
gross margin would be $200,000 or 61 percent.
Agriculture
The food industry begins at the farm, where the gross margin is around 56 percent. If farms have
a bumper crop one year, the supply may be greater than demand. In that event, the price could
drop and so would the gross margin. Crop failures, on the other hand, drive the price up. These
changes in prices spiral through to the final consumer, whether buying groceries or having lunch
at a fast food restaurant.
Manufacturers
Raw products are sold directly to the manufacturers or to wholesalers. For example, a ketchup
processor may buy the tomatoes directly from several farms or from a wholesaler, then adds
other ingredients such as vinegar and spices. Suppose it costs 63 cents to produce and distribute
a bottle of ketchup. A grocery store buys the ketchup for $1 per bottle and sells it at around $1.35
per bottle. Food manufacturers have an average gross margin of 37 percent and beverage
manufacturers 57 percent.
Retail Stores
Retail grocery stores have a gross margin of between 20 to 28 percent. These stores also offer
loss leaders -- low-priced deals designed to get customers in the door, where they'll presumably
buy other products as well. Product sales are not the only revenue stream for a grocery store.
Manufacturers pay stocking fees for new products to get them on the shelves, in order to mitigate
the store's risk. Retail space is precious. If a new product doesn't sell, the grocery store loses the
sales that would have been generated by products with a proven track record. The slotting fee is
categorized as a cost of sales for the manufacturer, decreasing the gross margin. The slotting fee
may be accounted for separately by the grocery store or simply netted against the cost of goods
sold, which increases gross margin.
Restaurants
Restaurant owners look at both the cost of food and the cost of beverages when setting goals for
gross margin. Beverages receive more markup than food. For example, a glass of ice tea even
with refills costs around 25 cents but sells for $1 to $2. The combined average gross margin for
both food and beverage runs between 59 to 62 percent. Food has an average cost of about 30
percent which results in a gross margin of 70 percent. Beverage has a cost of 20 to 25 percent
which results in a gross margin of 75 to 80 percent. In addition to the overall cost of food and
beverage, restaurant owners calculate the cost of each dish. That way, the owner knows what
menu items are making money and what items may have to have a price increase, an adjustment
in ingredients or be taken off the menu.
The Average Profit Margin of Pharmaceuticals
by Julianne Slovak; Updated May 14, 2018
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Pharmaceutical profit margins vary widely, from less than zero to more than 40 percent,
depending on the size of the company and whether it’s a powerhouse like Pfizer or Novartis or a
startup still in the research and development phase. The average net profit margin for drug
companies, including pharmaceuticals and biotech, was about 12.5 percent to 14 percent,
according to a January 2018 study by New York University’s Stern School of Business. But many
companies have margins far greater than that. Gilead Sciences and Amgen are among the most
profitable drug makers, with net margins of about 35 to 45 percent.
Pharma vs. Biotech
The Stern School analysis of industry profits makes a distinction between “drugs
(pharmaceutical)” and “drugs (biotechnology),” but the difference in profit margins is small. The
survey includes 185 pharmaceutical companies with an average net profit margin of 14.05
percent, and 459 biotechs with an average net margin of 12.57 percent.
The difference between pharmaceutical companies and biotechs is somewhat fuzzy. Both make
drugs, but they go about it differently. Pharmaceutical companies tend to use chemical processes
to produce medicines, while biotech firms look for biological agents like bacteria to come up with
and manufacture drugs. In practice, when analysts discuss drugs or pharmaceuticals, they
frequently lump pharma and biotech together.
The largest five drug companies (pharmaceutical and biotech) in the world by revenue in 2017
were Johnson & Johnson, Roche, Pfizer, Novartis, and Sanofi, according to a ranking by
Statista.com. Among the most profitable companies are Gilead Sciences, Amgen, Novartis,
Biogen, and Bristol-Myers Squibb, according to Biospace.com.
Criticism of Drug Companies

Pharmaceutical companies have some of the highest profit margins in the world, a distinction that
has earned the industry criticism from both politicians and consumers, who often complain about
the high prices of prescription drugs. According to a November 2017 report by the U.S.
Government Accountability Office, consumer spending on drugs has doubled since the 1990s,
mainly due to the high cost of prescriptions.
The same study pointed out that revenues and profit margins in the industry are on the rise. "We
looked into changes in the drug industry and found that pharmaceutical and biotechnology sales
revenue increased from $534 billion to $775 billion between 2006 and 2015," the GAO reported.
"Additionally, 67 percent of drug companies increased their annual profit margins during the same
period—with margins up to 20 percent for some companies in certain years." Spending on
research and development increased as well, to $89 billion in 2014, from $82 billion in 2008.
The Difference Between Service and Manufacturing

Income Statements
by Sean Butner
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Businesses summarize their earnings and expenses on regularly compiled income statements.
Income statements are the first financial statement that businesses prepare, providing investors
and managers with important information on the profitability of the company. While every
business has necessary expenses, manufacturing firms rely on converting inventory to products.
Manufacturing businesses typically prepare income statements that provide more detail about
expenses and revenues than do service firms.
Single-Step Income Statements

Service businesses prepare single-step income statements. A single-step income statement
discloses the firm’s profit or loss through the use of a single subtraction. Expenses are totaled
together on one line and subtracted from total revenues to equal the net profit or loss. Most
single-step income statements provide additional information by itemizing categories of expenses
and revenues.
Multi-Step Income Statement

Multi-step income statements separate operating revenues and expenses from nonoperating
revenues and expenses. Manufacturing businesses use multi-step income statements,
sometimes called classified income statements, to provide investors with more detailed
information about the health of their income. First, cost of goods sold is subtracted from sales
revenues to determine gross profit or loss. Then, operating expenses are subtracted from gross
profit to calculate operating income. Finally, nonoperating expenses and revenues are totaled up
and added to or subtracted from operating income to arrive at net income.
Indicators
Investors often look to income statements to assess the health of a business. Service businesses
are often compared in terms of profit margin, which is the ratio of net income divided by total
revenue. Manufacturing businesses, unlike service businesses, provide gross profit and operating
income in addition to net income. Investors may examine return on sales, which is operating
income divided by total revenue, and gross profit margin, which is the gross profit divided by total
revenue, when analyzing manufacturing firms.
Other Formats
When preparing income statements for internal use, accountants and managers have more
flexibility in how they format their statements. Many manufacturing firms prepare income
statements in contribution margin format, which itemizes fixed and variable costs per product, to
aid managers in setting sales mixture targets. Any income statements following a nonstandard
format must be appropriately labeled and kept away from public access.
Full-Costing Income Statement Vs. Variable-Costing

Income Statement
by John Freedman
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Costing?
Though you may be familiar with the traditional, full-costing income statement, managerial
accountants often work with another type of income statement. The variable-costing or
contribution margin format income statement is an alternative presentation of a company's recent
operations. The two statements contain different, but complementary information. Knowing the
differences between the two statements can help you use information from both of the
presentations to manage your small business.
Expense Classification - Behavior

Variable costing income statements group costs by cost behavior. That is, costs that do not
change as production levels change are said to behave in a fixed manner and costs that change
along with changes in production are considered variable costs. For example, a small-business
owner might incur expenses for rent, materials, labor and insurance when producing a consumer
product. The rent and insurance costs remain the same, regardless of the number of products
produced. However, the materials and labor costs will increase as the company makes more
products. Variable costing income statements will list a company's fixed and variable costs
separately on the face of the financial statements.
Expense Classification - Functional

Full-costing, or traditional, financial statements disaggregate costs by their functional area on the
income statement. This means that costs will be classified as costs of goods sold, selling
expense, administrative expense, general expenses or interest expense. The proportions of the
different types of cost incurred by a company can vary greatly across companies or industries. As
such, companies sometimes combine selling, general and administrative expenses. However,
generally accepted accounting principles prohibit combining these expenses with the cost of
goods sold.Typical selling, general and administrative expenses incurred by small businesses
include sales employee salaries, commissions, office supply expenses, office rent and
deprecation on non-manufacturing equipment. Common costs of goods sold include materials,
labor and overhead costs, such as factory rent, utilities and depreciation on manufacturing
equipment.
Gross Margin
Traditional financial statements contain a line called gross margin. A company calculates its gross
margin by subtracting the cost of goods sold from sales. Often, users of financial statements will
determine the gross profit percentage by dividing the gross profit by sales and use this figure as a
basis of comparing company performance. While this technique can be useful if the companies
are very similar, even some slight differences in production techniques, company size or product
sold can make this comparison less useful. If you wish to use your company's gross margin
percentage as a basis of comparison, the best plan may be to compare your own gross profit
percentage from period to period. However, know that changes in inventory levels can artificially
change this figure. As such, you'll want to look at multiple gauges of performance before
changing the way your company operates.
Contribution Margin
Variable costing income statements contain a figure known as contribution margin. The
contribution margin is calculated as sales less variable costs and is used in a managerial
accounting technique known as cost-volume-profit, or CVP, analysis. You can use CVP analysis
to quickly calculate your company's break-even level or production, how many products you'll
need to sell to achieve a target profit or determine how changes in sales will affect your firm's
bottom line. As such, the variable costing income statement, even though it is not appropriate for
external financial reporting, can be a useful tool for small-business management.
What Are Vertical Sales?

by Ian Linton
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Vertical sales are sales of a product or service to a limited number of market sectors, rather than
to all markets. A manufacturing company, for example, might design and produce products
tailored to the needs of customers in the aerospace and automotive industries. A professional
services company might tailor its services to the needs of clients in the insurance and banking
sectors. By contrast, a horizontal sales strategy is suitable for companies that market products
that meet the needs of a number of different industry sectors. Companies marketing office
supplies or maintenance services, for example, would operate a horizontal strategy.
Specialization
Companies with a vertical sales strategy develop products and services tailored to the needs of
groups of customers with similar requirements. By developing tailored products, they can
differentiate themselves from competitors that offer products suitable for all markets. A defense
supplier, for example, might specialize in a specific market niche such as components for naval
vessels,
Sales Organization
By organizing their teams according to vertical markets, sales managers can focus on increasing
market share in specific sectors rather than spreading resources across all markets. To succeed
in vertical sales, representatives must have an understanding of the specific needs, issues and
challenges of the industries they target. Some companies recruit only sales reps with experience
in a particular market to ensure they have the market knowledge and contacts to succeed.
Representatives with a good understanding of industry challenges can become trusted advisors
to customers, making it easier to build relationships and long-term customer loyalty.
Sales Costs
Companies selling to vertical markets must make an initial investment in recruiting and training
sales representatives and developing industry expertise. By developing strong relationships with
customers, companies can increase long-term revenue and reduce the cost of sales. It’s
important to identify opportunities for sales of additional products and services to customers in
vertical sectors and focus new product development programs on those opportunities.
Marketing Integration
To support sales in vertical markets, it’s important to integrate marketing campaigns with sales
drives. For example, advertising should aim to raise the company’s profile in the target sector as
well as generating leads for the sales force. A company's website should include product pages
focused on the vertical market, together with pages that describe the company’s capability in the
sector.
Direct Sales Model Advantages

by Eric Dontigney
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As a business moves from product development into product sales, it must choose between
several options, including the direct sales model. The direct sales model focuses on face-face
selling to individuals or small groups, typically by an employee or subcontractor for the business.
Businesses can also employ the Internet, which blurs the line between direct sales and direct
marketing, to augment the advantages of the direct sales model.
Cost Controls
Delivering products to end users through traditional methods, such as placement in retail outlets
or through wholesalers, can entail significant financial costs. Powerful retail outlets may demand
slotting fees to place a product on the shelves or insist the company pay for heavy advertising.
Some businesses avoid this through ownership of the retail outlet and wholesaler in a vertical
marketing system, but these outlets still require heavy investment in inventory, facilities and full-
time staff, regardless of sales. A direct sales model removes the wholesaler and retailer from the
equation, which allows the business to scale production and total staff to meet its actual needs.
This combination of factors reduces both the cost of entry and ongoing costs.
Relationship Building
The direct sales model, with its face-to-face approach, offers a means to help develop stronger
relationships with customers. Customers tie the products and the business to a person that they
may feel affection or loyalty toward. Social media enables individual salespeople and the
business to build on the relationships established during the in-person meetings between visits.
These multiple points of contact can help to turn a casual buyer into a loyal, long-term customer.
Because returning customers tend to yield a much higher profit due to the low acquisition cost,
direct sales provides an advantage over more impersonal, mass marketing approaches.
Adaptability
The use of a sales force that deals directly with customers can help a direct sales business avoid
issues like a bottom falling out of the market. Consumers can state explicitly what kinds of
products and services they want or need. Businesses can leverage these consumer-based
insights in new product development, as well as using the sales force to gather preliminary
response to proposed new products. The business can also scale back production or scale up
production based on direct sales figures, rather than relying on projected sales figures from
wholesalers or retail outlets that may not pan out.
Considerations
The direct sales model can also provide access to customers that a business might not reach
under normal circumstances, by way of the personal social networks of salespeople. Access to
these customers may not prove beneficial. Both salespeople and members of their social
networks may view the introduction of direct sales into personal relationships as opportunistic or
simply unwelcome. Companies employing a direct sales model also tend to experience high
levels of turnover among sales staff. High turnover means the business must plan to engage in
persistent recruitment and maintain meticulous records to keep sales numbers consistent, as well
as continuing to provide service to existing customers.
How Does Overinflated Inventory Affect Net Income?

by Eric Bank
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 What Does Decreasing Inventory Turnover Mean?
 How Does Inventory Affect Cash Flow?
 Explanation of Merchandising Manipulation in Accounting
 How Does Understated Ending Inventory Affect Equity?
 Does Inventory Adjustment Effect Equity?
A business that sells inventory might misstate the value of ending inventory. The mistake might
be innocent, but at other times it might represent earnings management or worse. The Internal
Revenue Service requires companies to take physical inventory counts at reasonable intervals to
adjust inventory value. Overstated inventory hurts shareholders, because it increases taxable
income -- the company will pay more income tax than it should.
Financial Reporting
You report net income at the bottom of the income statement. At top, you report sales revenues
and then subtract the cost of goods sold to figure gross profits. COGS is equal to beginning
inventory plus inventory purchases minus ending inventory. If you overstate ending inventory,
COGS will be too low. This increases gross profits, net income and taxes. The effect shows up on
the balance sheet as well. Inventory is a current asset -- if you overstate it, you also overstate
owner’s equity, which is the difference between assets and liabilities.
Overstated Inventory
You can overstate inventory through miscounting and by applying the wrong costs to inventory on
hand. Miscounting can occur through human error or deliberate action. For example, inventory
counted on one day might move to another location where it is double counted on a subsequent
day. If you maintain a perpetual inventory, you might not become aware of stolen or damaged
inventory until you take a physical count. You might also overstate inventory by failing to
recognize when the net realizable value of inventory drops because of reasons such as damage,
obsolescence or government recall.
Shrinkage
Shrinkage is the loss of inventory due to shoplifting, employee theft, supplier fraud and paperwork
errors. The National Retail Security Survey estimated U.S. shrinkage at $34.5 billion in 2011,
representing 1.41 percent of retail sales. Although this represents an improvement over 2010
figures, shrinkage clearly is a substantial problem that, if not discovered, can lead to overinflated
inventory. Companies that rarely take physical inventory may need to make significant
adjustments after conducting a count.
Earnings Management
Some companies set up compensation incentives that reward managers for achieving profit
targets. Morally challenged managers might overstate inventory to increase net income through a
number of ploys, including fictitious goods, manipulated counts and non-recorded purchases.
Auditors look for signs of ghost inventory, such as inventory increasing faster than sales or total
assets. Other tip-offs are fraudulent inventory count sheets, fairy-tale shipments and bogus
purchase orders. If not caught, then inventory overstatement scams not only increase earnings,
they line the pockets of complicit executives.
otal Sales vs. Total Revenues

by Sam Ashe-Edmunds
RELATED ARTICLES
 Return on Sales Ratio Example
 Difference Between Cash Flow & Sales Revenue
Many small-business owners make the mistake of seeing sales and revenues as synonymous,
which can lead to less effective planning and results tracking. Sales have more to do with the
volume of business transacted, while revenues are the amounts of money generated from sales.
Neither gives you an exact picture of profits or margins, but they are tools you can use to analyze
your marketing efforts.
Sales
Sales occur when someone pays you for your product or service. You can increase sales and still
lose money. If you don’t correctly calculate your cost of production and overhead, you might set
your prices too low, losing more money as sales go higher. Total sales refers to the total number
of units you sell, regardless of how much money you bring in or whether or not you make a profit.
If you use the term “sales” to refer to the amount of money you bring in, your total sales would be
your total dollar volume.
Revenues
Revenues are the monies you generate from sales or other activities. For example, if you sell 100
tennis rackets at $30 each, your total revenue from those racket sales is $3,000. If you sell 50
tennis rackets for $70 dollars each, your total revenue for those sales is $3,500. Your total racket
sales are 150 and your total revenues are $6,500. Increased revenue doesn't necessarily mean
you are making a profit or you have more money to spend on advertising or salary increases or to
pay down debt or purchase new machinery. You can also generate non-sales revenues from
interest earned, royalties, commissions and other means.
Margins
Products or services that produce the highest sales and highest revenues aren’t always your best
bets for profitability. For example, looking at the tennis racket example, the lower-selling racket
produced the higher total revenue because of its higher price. Your biggest revenue producer,
however, might not be the product you want to focus on.
If one of your products generates the most revenue but costs more to produce and sell, your
profit margin will be lower. For example, the tennis rackets that produced $3,500 in revenue might
only have produced a profit margin of $1 per racket, while the rackets that only produced $3,000
in sales turned a profit of $3 per racket. Setting sales staff quotas and commissions might
motivate your staff to sell more of your less-profitable items.
Return on Investment
When analyzing your sales, revenues and profits, look at the return you get from your investment.
A more profitable product might cost you more money to sell. For example, if you make a larger
profit on one product than another, but the more profitable product gives you a 2 percent return
on your investment and the less-profitable product gives you a 10 percent return on your
investment, you’ll need to invest more money to make a profit.
If you can take your money and invest it in a financial instrument that gives you a 3 percent return
on your investment, it might make more sense to do that than to sell the product that made you a
2 percent return. A better option might be to increase sales of the product that brought you a 10
percent return on your investment, even if it has lower profit margins or total profits. You won’t
need to invest as much and can use your extra cash for something else.
Balancing Act
Carefully analyze the combination of sales, revenues, margins and return on investment that
produces the best results for you. Successful small businesses look for the right combination of
sales potential, revenue development and profit margins to maximize their return on investment
or profit, depending on how much money they have to work with. For example, if you have a
small amount of money to invest, you might want to maximize your total profit from that
investment, rather than your percentage profit. If you have considerable funds to invest,
maximizing profits with a product that gives you a small return on your investment prevents you
from using funds for other more lucrative investments.
Differences Between Effectiveness & Efficiency in For-

Profit Organizations
by Neil Kokemuller
RELATED ARTICLES
 How Effectiveness & Efficiency Relate to Productivity

 Goals & Functions of a Business
 Porter's Generic Strategy
 Measurable Objectives in a Business
Effectiveness and efficiency are business terms often used interchangeably or in a general
combination. Effectiveness refers to your ability to optimize business strengths in the way you
operate. Efficiency refers to your ability to optimize your resources and business activities to
generate revenue and profits.
Current Operations
Effectiveness can include discussion of current operations and opportunities for improvement. If
your business is currently effective, you are using your core strengths and available resources to
best serve the marketplace. A for-profit business with a strong customer service staff is effective if
it earns healthy revenue by providing a high-level of sales and service production. An effective
manufacturing firm uses its buildings, equipments and workflow to produce quality goods.
Improvements
The activities that make you effective now may not contribute to continued effectiveness.
Therefore, it is fair to say that effective companies consistently look for opportunities for growth
and development. If an emerging market develops that your company can serve, effectiveness
means that you conduct research, recognize the needs and interests of the market, develop
products and services to match and promote your brands well to the target customer base. Your
company’s effectiveness is somewhat relative to the ability of competitors to produce similar
business results with the same resources and opportunities.
Cost Controls
Efficiency generally refers to how well you convert business investments into revenue and profit.
One factor in efficiency is cost control. Efficient companies usually only spend money that
produces tangible gains in customers, revenue or profit. Paying competitive wages while
motivating employees to produce the highest goods or sales contributes to efficiency. Paying only
for product developments that lead to enhanced customer perception of value is another element
of cost control and efficiency.
Profit Maximization
On the revenue side, sales conversions and revenue optimization contribute to efficiency in profit-
generation. A sales-driven company often measures selling efficiency by comparing the number
of sales an employee creates to the number of prospects he meets with. A business may similarly
compare its foot traffic to its sales dollars to measure efficiency. Improvements in areas such as
visual merchandising and sales and service training contribute to optimized sales conversations
and better customer retention. Both of these factors contribute to optimized revenue and profit.
The Average Return on Equity for the Grocery Store

Industry
by Steve Lander
RELATED ARTICLES
 What Percentage Should Return on Assets Be for a Company?

 What Businesses Have the Highest Return on Equity?
 What Financial Ratios Are Important to the Retail Industry?
 Difference Between ROA & ROC
 What Is the Profit Margin Expected on Chocolate?
According to CSIMarket, the average return on equity for the grocery industry was 12.82 percent
in the third quarter of 2013 and 19.97 percent in the fourth quarter of 2012. Professor Aswath
Damodaran of New York University's Stern School of Business tracked a 16.33 percent return on
equity for the retail and wholesale food sector, as of January 2013. This data reflects publicly-
traded grocery companies.
Return on Equity
Return on equity measures the profit earned by a grocery store relative to the amount of money
invested by its stockholders. To calculate ROE, divide a grocery store's net income by the
average amount of equity for the time period during which the income was earned. Generally,
grocery stores offer lower risk than other retailers because demand for groceries is relatively
inelastic, so they offer lower returns compared to other companies in their sector.
Alternative Return Metrics

While return on equity is a useful metric for large grocery store companies, it isn't the only one
that grocery store operators can use to judge their operations. Return on asset ratios measure a
store's profitability relative to the items of value on its balance sheet. The return on sales ratio,
also known as the operating margin, measures how much money a store generates relative to its
sales activity.
Typical Grocery Store Returns

Data from the Retail Owners Institute shows that food retailers generated an average profit
margin of 1.9 percent in 2013. The average return on assets was 7.5 percent for 2013. Data from
BizStats.com, which is based on aggregated data from tax returns for the 2010 year, shows an
average return on sales rate of 2.3 percent and an average return on assets of 6.34 percent.
Grocery Store Margins

One of the main factors driving grocery stores is that they operate on relatively thin margins.
According to grocery analyst Jeff Cohen, margins of 1.3 percent are typical. This happens in part
because of competition from other major low-price grocery retailers like Wal-Mart. At the same
time, grocery stores have to deal with spoilage, which renders large portions of their inventory
unsellable and cuts into their margins. Spoilage also necessitates high rates of inventory turnover
-- 14 times per year, on average, based on 2013 data from the Retail Owners Institute.
A Disadvantage of a Low Profit Margin

by Raul Avenir
RELATED ARTICLES

 What Is a Pretax Profit Margin?
Profit margin, or net profit margin, is a ratio analysis tool that helps you improve your company's
ability to generate a profit, but you won't benefit from using this tool unless you know how to
interpret it. Having a low profit margin is similar to entering a danger zone. Knowing the
disadvantages that this type of margin can brings makes you aware of the financial pitfalls you
must avoid when steering your business.
Low Profit Margin

Profit margin refers to the percentage of sales converted into net profit. Dividing net profit by
sales for a given accounting period and multiplying the product by 100 will yield the profit margin
expressed in percentage. For example, a company that earned a net profit of $10,000 from total
sales of $100,000 will yield a net profit margin of 10 percent: 10,000 divided by 100,000 multiplied
by 100. Low profit margin is one that falls below the average profit margin of businesses within a
specific industry.
Price Adjustment
A low profit margin can leave you very little room to lower your selling prices. Lowering the selling
price is sometimes necessary to have an edge over competition or to implement pricing
strategies. A low margin means there is little funds available for profits and expenses. Lowering
your selling price without a corresponding and proportional reduction in cost of goods sold will
further reduce the funds available for expenses and profits. A business manager should avoid
reducing selling prices when the profit margin is low to avoid cash flow problems and low
profitability.
Expenditures
Low profitability prevents business managers from increasing expenditures. Expenses that are
intended to provide future benefits, such as marketing expenditures allocated to boost sales, are
necessary to maximize profitability. With all things being equal, an increase in expenses
decreases profitability. In the case of a low profit margin, increasing expenses will further push
the margin down to a lower level.
Less Profit
The biggest disadvantage of a low profit margin is poor operational efficiency. Profit margins that
are lower than industry average margins are indicative of the need to improve performance. It
shows that most businesses within the industry are managing their operations better than you
are. The lack of improvement results to a profit level lower than what is attainable.
Retail Method for Gross Margin Calculations

by William Adkins
RELATED ARTICLES

When you run a retail business, closely monitoring costs relative to sales is essential to
profitability. Gross margin allows you to track how much money you have to pay in operating
expenses and allow for making a profit. In turn, this helps prevent unpleasant surprises when it
comes time to figure your business’s profitability.
Description
Gross margin, or gross profit margin, is the difference between the cost of goods and net sales.
Net sales are the dollars actually received for the goods sold. Don’t confuse gross margin with
markup. A retail markup is a percentage of the cost of goods that is added to the cost of goods to
determine a retail price. Typically, businesses calculate gross margin for the entire retail
operation, but it’s sometimes useful to figure gross margin for product categories and specific
products in order to assess their profitability compared to other goods offered for sale .
Cost of Goods
Before you can calculate gross margin, you must determine your cost of goods. In a retail
business, it is the total expense required to acquire you inventory. Retail cost of goods normally
includes the price paid for inventory plus allowances for losses due to breakage or spoilage. For
example, if you pay $40 for a particular item, you might add $1 for allowances, giving you a total
cost for the item of $41.
Calculating Gross Margin

Determine net sales by subtracting returns from your gross receipts. Then subtract the cost of
goods from net sales. The result is the dollar amount of your gross profit margin. Convert the
dollar amount to gross margin percentage by dividing the gross margin in dollars by the net sales,
and then multiply the result by 100. For instance, if net sales total $2,000 and your cost of goods
is equal to $1,400, your gross margin is $600. Dividing $600 by $2,000 works out to a 30-percent
gross margin percentage.
Significance
Gross margin is useful for assessing the impact of discounts and changes in the cost of goods on
your potential profit. It also allows you to determine if prices are high enough to cover cost of
goods plus operating expenses, and still leave room for profit. Gross margin also serves as the
basis for calculating net profit margin. Net profit margin is your gross profit margin minus
operating expenses. The net profit margin serves as a measure of operating efficiency, meaning
how well you are controlling operating costs in your business.

The Best Metric of Success For Companies

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The Best Metric of Success For Companies

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The best metric in SaaS —

We found only 8 publicly traded SaaS companies that even

-By the 3rd year, the customer is thoroughly

-After the first year, contribution margin is

 Share on Fac ebook

Margin analysis first identifies areas where gross and

Most retailers are struggling to maintain profits because product

Gross margin vs. contribution margin

We might as well call gross margin the mythical margin. Like a

Figure 1: All of the things eating margins

Despite a lengthy list of contribution margin factors, the 80-20 rule

Contribution margin = offer price – PO cost – shipping cost +

Pricing optimization and vendor negotiation

Figure 2 illustrates the story of profitability as gross margin vs.

Figure 2: Sample SKU for a children’s backpack

In another example — Figure 3 — Jet.com offers free shipping for a 24-

Margin analysis first identifies areas where gross and contribution

Accelerated product lifecycles and market demand for wider

Managing availability per channel

For omnichannel retailers, the cost structures can differ significantly

Figure 5: Online versus in store costs

Returning to the issue of prohibitive shipping costs, as with the bottled

When planning a strategy, gross margin is a blunt weapon with limited

Boomerang Commerce provides price-optimization technology and

Contribution Margin Vs. Gross Profit

What Could Cause an Increase in Profit Margin?

 How to Have a Low Net Profit

About the Income Statement

Gross Versus Net Profit

Trends in Managerial Accounting

 What Is CVP in a Company?

Costs of Goods Sold

 What Is Considered a Normal Profit Margin?

CVP analysis, or cost-volume-profit analysis, is used in managerial accounting to use the

What Is Considered a Good Gross Margin Percentage?

 What Does a Low Gross Profit Percentage Mean?

What is Gross Margin?

What Does a Low Gross Profit Percentage Mean?

 How to Increase Gross Margin

Cost Leadership and Competitive Advantage

 How to Increase Gross Margin

What Is a Blended Gross Profit Margin?

 What Are Profit Margins?

Divisional Revenue and COGS

Other Profit Margins

Profit Margin Formulas

(Total Combined Sales - Total Combined COGS)/Total Combined Sales

Operating margin = Operating Income / Total Sales

Net Margin = Net Income / Total Sales

How to Increase Gross Margin

 Why Is Inventory Important for a Business?

Better Inventory Management

How to Fix Your Profit Margin

 Retail Method for Gross Margin Calculations

Calculate Growth Rates

How to Figure Gross Margin on a Restaurant

 How to Fix Your Profit Margin

Cost of Goods Sold

Calculate Gross Margin

Calculate Gross Margin Percent

The Three Elements of a Profit Margin

 What Is a Pretax Profit Margin?