An Important Metric Every Business Owner Needs to Track

One of the most common metrics many small business owners measure is turnover. They gauge the success  of their business based on the growth in turnover from year to year.

When a peer asks how business is going, we boast that turnover has increased by X percent, or the dollar value of the turnover being reported. However, measuring revenue as an indicator of business performance is, at best, pointless.

It fails to take into account the gross margin made on the sale. For instance, if a product or service is priced at $100 and the cost of producing it is $90, the gross margin on the sale is $10 or 10%.

What does this mean? For every product sold, there is $10 available to pay for overhead or fixed costs such as rent, wages, and insurance. If the cost of producing the sale increases, the amount of funds available to pay for the fixed costs decreases, and hence the business net profit suffers.

There’s another drawback to focusing solely on revenue as a metric. For instance, if the volume of sales increases, and the gross margin remains constant, the additional labour costs required to manage the increase in sales volume may lead to lower business profits.

Increase Net Profit By Focusing on One Valuable (Yet Often Neglected) Metric

Gross margin is a valuable indicator of a company’s survival and profitability. It is the difference between the selling price of a product or service and the cost of producing it. Instead of focusing on increasing turnover, concentrate on strategies to increase the gross margin for a more profitable outcome.

You can start by implementing efficiencies or negotiating cheaper prices from suppliers. If you can bring down the cost of selling a product or service, you will be able to raise the gross margin.

For example, reducing the cost of a product by $5 increases the gross margin by $5 or 15%.  This gives the business owner much better returns for his efforts than trying to increase the revenue by 50%.

Let’s do the numbers, based on the example above:

Sales of 5,000 items at $100 per item

Total revenue:            $500,000

Cost of sale per item: $90

Total cost of sale:       $450,000

Total fixed costs:        $45,000

Net profit:                   $5,000

Increase in turnover:  40%

Sales:                           7,000

Total revenue:             $700,000

Cost of sale:                $630,000

Gross Margin:             $70,000

Total fixed costs:         $45,000

Net profit:                    $25,000

*This assumes there’s no extra labour costs required to generate the increase in volume of sales.

Decrease in cost of sale:    $5

Sales:                                   5,000

Total revenue:                   $500,000

Cost of sale per item:        $85

Total cost of sales:            $425,000

Gross Margin:                   $75,000

Total fixed costs:               $45,000

Net profit:                          $30,000

This example demonstrates how focusing on increasing gross margins rather than sales volume can be a far more effective method of improving the viability of the business. A decreasing gross margin can hurt your cashflow. Adequate gross margin assures that you will still have enough money to cover the rest of your business expenses.

Monitor your gross margin and devise strategies to increase it. While sales and profit matter, improving gross margin is equally (or even more) important to keep your business alive and thriving. It’s a metric you cannot neglect.

So next time a peer asks about your turnover, try to steer the conversation to a much more realistic metric: gross margin.