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8.8 Gross Profit Margin Analysis Questionnaire

What is the Gross Profit Margin ratio and why is it so important to a business owner like Felix Gonzalez?

The Gross Profit Margin ratio is a very important profitabilty ratio used widely in all industries and businesses and it is very important to a small business owner like Felix Gonzalez because it gives him a very clear idea of what kind of cushion a small business has after it has paid for its cost of goods sold. This cushion is what determines the profitablity of a company and the next item that is subtracted from the gross profit to get to the operating income is of course the operating expenses. Thus having a good Gross Profit Margin ratio is critical to all small businesses like Central Plumbing & Heating Inc..

Gross Profit Margin is arrived at by dividing the Gross Profit by the Sales / Revenues of the small business. Thus you would start with the revenues and subtract the cost of goods sold to get to the Gross Profit and you would take that number and divide it by the Sales to get to the gross profit margin ratio. Clearly as you can imagine, the higher the gross profit margin, the better it is for the business since it indicates a much larger cushion for the business to be able to pay its operating expenses.

Gross Profit Margins is a very good measure of just how well the revenues of a small business like Central Plumbing & Heating Inc. are able to meet the cost of goods sold. It is important to note that for service oriented small businesses like realtors, lawyers, dentists etc, the Gross Margin will be very high since they typically do not have a cost of goods sold - in their case the cost of goods sold is included in the operating expenses.

Does a declining Gross Profit Margin indicate that a small business like Central Plumbing & Heating Inc. could be in trouble?Yes. The Gross Profit Margin ratio for a small business like Central Plumbing & Heating Inc. would decline in the event either the Cost of Goods Sold for the business have gone up and / or the Sales for the business have gone down. In the event the cost of good sold increase, it could indicate that the cost of raw materials and other direct costs associated with the procurement, manufacture or creation of the goods have increased. Typically this would entail the small business either raising its prices so its sales numbers increase and they can maintain their Gross Profit Margin ratios or then they would have to decrease their operating expenses to remain competitive. They may also consider reducing their Cost of Goods sold by switching or looking for cheaper suppliers for their wholesale inputs where applicable.

On the other hand the Gross Profit Margins could also be decreasing due to a decrease in sales activity. An increase in costs resulting in an increase in the Cost of goods sold is one of the main reasons that businesses have to raise prices and in the event a small business owner like Felix Gonzalez sees that their Gross Profit Margins are getting squeezed, the business may well have to increase prices to be able to survive. Taking a fresh look at the sales strategy may also be warranted and the small business may want to change its branding and positioning to be able to go after larger sales numbers.

Gross Margins are a key profitability indicator and the reason so many analysts, lenders and potential partners look at this number carefully is because if the Gross Profit Margin numbers are tight to begin with, then the business will have very little room to pay down its operating expenses, interest and other obligations.

Does having a higher Gross Profit Margin than the competition give a small business like Central Plumbing & Heating Inc. an advantage?

Yes. If a small business like Central Plumbing & Heating Inc. has a better Gross Profit Margin than its competitors it means quite simply that they will be able handle tougher times much better. Why? Simple - they have a larger cushion. Having a higher Gross Profit Margin than the competition gives a small business owner the ability to absorb the operating expenses of the business much better and also have a much better cushion to be able to pay off the interest and notes that the business is responsible for. Thus if things were to slow down in Mecklenburg County, North Carolina the business would be able to survive the downturn much better than the competition who will have very little cushion left given their higher Cost of Goods Sold resulting in lower Gross Profit Margins.

Having a better Gross Profit Margin than the competition also gives a small business like Central Plumbing & Heating Inc. the ability to have a much better chance at raising capital from lenders and potential partners and that of course is yet another advantage for the business. Competitors with lower gross profit margins will most certainly have a tougher time getting financing since lenders and potential partners will want to know how the business will pay them back in tougher times when sales slowdown and they have no cushion left.

In the case of a retail oriented business, the Gross Profit Margins between two small businesses can literally mean the difference between success and failure. Almost invariably the business that is able to survive the downturn and take advantage of opportunities will be the small business with the higher Gross Profit Margin. Sometimes in the retail business, Gross Profit Margins can be wafer thin and profitablity depends almost completely on volume. This is a trend that we have been noticing in almost all retial oriented businesses. The Walmart story is a story of low gross profit margins but huge sales volumes making up for the loss of profitability on each product. This low cost provider with low Gross Profit Margin model works well for large businesses but we caution our small business clients from taking on this approach.

A small business will seldom be able to compete with the big boys when it comes to cost - especially in the retail world. You have to choose to provide the market place with a special service or unique value that the clients are not able to get from larger names. Thus you will find that there are very few retail establishments that offer the average male customer clothes to wear, and this is quite simply because, these customers tend to go to the larger retailers like Sears, Macy's, Nordstrom etc to get their clothes. On the other hand you will find small businesses offering custom tailoring services along with high end boutique names that cater to the wealthy and don't have very large scaled retail presence. These are examples of how small businesses can thrive in the retail world of very thin Gross Profit Margins.

Quick Links:

  1. Go to the Corresponding Template section for this industry.
  2. Go to the Corresponding Business Plan section for this industry.

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