A business will not be able to generate the amount of operating profit it needs if it fails to generate sufficient gross profit. Fixed expenses can be reduced, but this move has its limit. After that, the business’ ability to earn revenue will be impaired, thus weakening its ability to generate the needed amount of gross profit.
So, it appears that gross profit is highly important, at least in the P & L. And, it is also the determining factor in how much operating profit a business can earn.
We now live in a world where can gain access to an infinite amount of information, and for businesses, this means competition is fiercer than ever. Businesses are feeling the pressure to keep gross profit margin (%) at a certain level or increase it. There are several factors that impact gross profit and/or GP margin: labour issues and material issues.
1. Materials
Failure to pass on materials cost increases
This can be due to adverse changes in the freight or FX rate for imported materials or increases from local or global suppliers. Make sure you are passing on these increases to your customers. It’s not easy to do, but look for and apply price increase for those goods or services where you can. Or you can look for other suppliers with trading contracts that fit your business, including lower prices for materials of the same quality.
Product Mix
All businesses need to check their financial statements at least every month. Doing will allow you to detect the rise and fall of GP margin from one month to another. The fluctuations could be the result of the assortment of services or goods the business has sold for a particular month. A motor body builder, for instance, may have more job orders in the month that have a huge amount of third party parts like toolboxes and cranes. These jobs will tend to be of higher value but have lower GP margin. In addition, frequently the price of a higher value job will have to be set steeper to boost the probability of winning it.
Fix your lowest possible GP margin for the job that you believe will play a part in generating the total gross profit dollars needed for that particular month, and make sure not go lower than that set margin.
Pilfering of Materials
It may not be pleasant to find out that one of your employees is stealing stock, but the reality is it happens. Put into effect measures to counteract it such as setting up and implementing good systems, recruitment procedures, CCTV and culture development programs.
Insufficient materials inward system
Some businesses have experienced paying large sums of money to merchants for materials that suppliers fail to deliver. This is one of the fastest ways a business loses money, but the easiest to resolve. Assign an individual with a keen eye for detail to oversee the materials in, and implement an effective system for physically verifying materials that come in against the merchant’s delivery docket and invoice for each delivery.
Failing to allocate materials that are utilised
It occurs often in manufacturing companies where work orders are quoted that comprise a fixed amount of materials, and then additional materials are utilised for the job but not put in the job card. The most common reason for this is employee errors that need additional materials to fix the mistake, and they don’t notify somebody. Another reason is materials being overlooked in the initial cost estimate. It will benefit you to put in place effective systems for correct quoting, excellent hiring procedures to ensure only quality workers are hired, and great employee training and mentoring programs.
Significant wastage of materials
There are several reasons why this can occur, including materials that are obsolete, damaged or outdated and thus cannot be used or sold. Moreover, it can happen when material wastage is not taken into account adequately when costs are estimated. Make sure to implement effective purchasing and warehouse procedures to lessen the probability of having unsaleable or unusable materials, and evaluate your cutting and quoting systems.
Stocktake or valuation process is inaccurate
During the preparation of management reports or financial statements, the closing inventory balance is affected by the cost of sales (and gross profit). If you overstate the closing inventory balance, you’d end up with an overstated gross profit as well. And if you understate inventory, then you’d have an understated gross profit. A business with no process to oversee stock control and valuation on a regular basis cannot rely on the correctness of the management reports.
Incorrect work in progress or progress claims accounting
When preparing its management accounts at each month’s end, a project or manufacturing business has to take into account the effect of progress claims, work in progress (WIP) and customer deposits. The fundamental idea is to balance income and expenditures associated with each other in identical periods. Depending on the requirements, compute the WIP and eliminate it from the P&L pending the completion of the job or keep the WIP on the P&L and accrue the income associated with the job. Doing this task also involves factoring in the effect of deposits and progress claims to make sure income is inputted in the right period.
2. Labour
Computing labour costs in WIP
Computing WIP is complex. It is easy to compute the outlay of materials for WIP, but labour outlay is not as simple. The labour cost for WIP should comprise: payroll tax, work cover, superannuation, allowances, overtime and base salary.
Significant rework or warranty work
Labour outlay related to rework and warranty work can become an opportunity cost for business when it entangles labour that could be better utilised in other gross profit and revenue generating assignments. To minimise rework and some warranty jobs, effective systems, hiring, training and mentoring are needed. In addition, commence evaluating your warranty policies and have a more extensive inspection of what’s happening in quality, if you are seeing a significant degree of warranty work.
Mistakes in Bookkeeping
There are a few ways this could happen. First, a simple data entry typo into MYOB that bloat the cost of sales amounts, or more uncommon is paying a supplier invoice for materials twice. Make sure you hire a competent bookkeeper, and that your accounting documents are checked by your accountant each month.
Fraud
Like the discussion on theft, employers also hope that their staff are honest and follow the core values of the company. However, fraud can happen. A common type of fraud that directly hits gross profit is a “billing scheme.” This is comprised of three parts: setting up a fake entity to take payments, making a fake invoice or falsifying a genuine invoice to be presented for payment, and manipulating the payments process to allow the false invoice to be approved and paid. Ask the help of your accountant in putting in place effective systems to prevent fraud as it can really damage the business when it does happen.
Low pricing
This is commonly the biggest cause of low GP margin and happens due to several factors: incorrect cost estimate or low charge out due to the inaccuracy of the labour rate and materials costs. There is also discounting pricing to garner a significant amount of jobs, frequently by sales representatives in companies that has insignificant policy and tracking of pricing. Competition among businesses is becoming fiercer every day. If you are engaged in a battle for competitive pricing, you must realise it is only for a short term. If you are envisioning long term, you have to evaluate your business model, and fast.
Worker productivity
Productivity means the volume of output compared to the volume of input. Worker productivity can decline due to factory lay-out, low worker skill level and experience, and overall distractions like excessive socialising during work hours. This will raise the variable cost compared to revenue, thus lowering the GP. This can also be caused by the failure of keeping the work (sales) up to them because frequently a business can’t trim down its skilled variable labour element to equal work demand. It can also happen if excessive overtime is permitted. Strive to cut waste throughout the organisation by carrying out lean principles, creating training programs and instituting a culture of high productivity. One way that employers can monitor worker productivity monthly is revenue divided by the number of variable labour hours.
Minimal labour rate charge out
When computing for a quote, make sure that the hourly labour rate charge actually reflects the existing variable labour cost condition. Costs must be reviewed regularly to make sure salaries, work cover, superannuation, payroll tax, average overtime, all award allowances, all kinds of leave, non-productive time, and an allowance for write off, like over-runs and warranty, are accurate.
Summary
A lot of well established, historically and financially stable organisations are being caught unaware by how fast change is happening in the new global business environment. The media plays this out every day. If you don’t see it within your company, you have to establish a culture of change and innovation.
An important question to ask yourself as you move into the planning stage for 2016 is: What instant changes should I do to make sure my business is still sustainable and prospering in five years?
PJS Accountants offers expertise in helping improve your business and take it to the next level. We work to understand your business and its inner workings and how it can compete effectively in the present business environment. From this knowledge, we can come up with a custom plan to implement your business strategies and methodologies, boost profit and increase market shares. Visit one of our specialist advisors or contact PJS Accountants.
