Business is about margins
What is a margin?
A margin is the difference between the price at which a product is sold and the costs associated with making or selling the product (or cost of goods sold). Margins are some of the most important performance metrics for businesses to track. A company can be bringing in enormous revenues, but if it has very high operating costs, its profit margins are likely to be small or non-existent.
When margins are disproportionately low, you must find ways to reduce costs or boost revenues. The focus of this article will be on Gross Profit Margin (GP) and Net Profit Margin (NP).
A company’s gross profit margin refers to the profits the company makes after variable production costs have been deducted, but before fixed costs have been accounted for.
Net profit margin is calculated by deducting all expenses outside of the cost of goods sold (COGS). There is more than one formula for doing this; however, the simplest way is to start with the net income for the period. This is found on the bottom line of your company’s income statement. Divide this figure by your total revenue and multiply the resulting figure by 100. This gives you your net profit margin as a percentage.
Here is an illustrative example
Mr. B is a chef and currently runs a restaurant that bakes delicious pastry, they are famous for their giant muffins. The restaurant is based at a local mall and pays a monthly rental amount of R5 000. The business currently employs a total of 2 people who each earn R4 000 per month. Mr. B has done his homework and has calculated that it costs him a total of R10 to bake a giant muffin from beginning to end, including packaging. Each muffin is sold to customers for R25, all inclusive. During month 1, Mr. B sold a total of 1500 muffins. During month 2, Mr. B sold a total of 1000 muffins. During month 3, Mr. B only sold a total of 500 muffins.
Month 1 – Mr. B sold a total of 1500 muffins
Total Sales will be R37 500 (1500 x R25) and the total cost of sales will be R15 000 (1500 x R10). The total Gross profit will be R22 500 (R37 500 – R15 000). This means that for each unit sold, the Gross profit per unit is R15 (R25 – R10) or 60% (R15/R25 x 100). Gross profit is calculated and determined before taking into account overheads such as rent and salaries.
The total overheads in this case are rent, which is R5 000, and salaries, which are R8 000 (R4,000 x 2). These bring the total to R13 000. From the above, remember our gross profit is currently R22 500. In order to calculate the net profit, we then need to subtract the overheads from the gross profit. Net Profit = Gross Profit – Overheads. This will give us a net profit of R9 500 (R22 500 – R13 000) or 25% (R9 500/R37 500 x 100).
Month 2 – Mr. B sold a total of 1000 muffins
Total Sales will be R25 000 (1000 x R25) and the total cost of sales will be R10 000 (1000 x R10). The total Gross profit will be R15 000 (R25 000 – R10 000). This means that for each unit sold, the Gross profit per unit is R15 (R25 – R10) or 60% (R15/R25 x 100). Gross profit is calculated and determined before taking into account overheads such as rent and salaries.
The total overheads in this case are rent, which is R5 000, and salaries, which are R8 000 (R4,000 x 2). These bring the total to R13 000. From the above, remember our gross profit is currently R15 000. In order to calculate the net profit, we then need to subtract the overheads from the gross profit. Net Profit = Gross Profit – Overheads. This will give us a net profit of R2 000 (R15 000 – R13 000) or 8% (R2 000/R25 000 x 100).
Month 3 – Mr. B sold a total of 500 muffins
Total Sales will be R12 500 (500 x R25) and the total cost of sales will be R5 000 (500 x R10). The total Gross profit will be R7 500 (R12 500 – R5 000). This means that for each unit sold, the Gross profit per unit is R15 (R25 – R10) or 60% (R15/R25 x 100). Gross profit is calculated and determined before taking into account overheads such as rent and salaries.
The total overheads in this case are rent, which is R5 000, and salaries, which are R8 000 (R4,000 x 2). These bring the total to R13 000. From the above, remember our gross profit is currently R7 500. In order to calculate the net profit, we then need to subtract the overheads from the gross profit. Net Profit = Gross Profit – Overheads. This will give us a net loss of -R5 500 (R7 500 – R13 000) or -44% (-R5 500/R12 500 x 100).
Conclusion and takeaways
Based on the above three scenarios, we can see that the gross profit remains unchanged irrespective of the number of units sold. This is because gross profit is determined at a unit level. Therefore, no matter how many units you sell, your gross profit should remain unchanged. It is therefore very important to correctly determine your cost of goods at a unit level so that you can know what your profit is when you sell each unit.
Once this has been determined, the next step would then be to determine how many units you need to sell in order to cover your fixed costs and make a net profit (i.e. the breakeven point). Based on the above three scenarios we can see that the more muffins Mr. B sells the more profit he makes. In other words, net profit and net margins are impacted by the change in volume of sales.
You are in business to make a profit, so these are key margins to track in your business!
Tel: 010 596 5902 | Mobile: 066 086 6065 | Email: office@firstplace.co.za | Instagram | Facebook | LinkedIn | YouTube | www.firstplace.co.za
