Every number on your income statement is important, but few are as critical as gross profit. Lovely, lovely gross profit. The sales line measures how much product we sell to the retailer, but gross profit measures how much of the sale distributors get to keep to cover operating costs.
About 75% of sales dollars go straight to the supplier, freight carrier and tax man. On $100,000 of sales, $75,000 is already spent. Sales are for the supplier, but gross profit is for the distributor. In this article we will review a 3-step process to improve your gross profit so that you can grow the bottom line.
Three Steps to Improve Gross Profit
- Know your gross profit (GP). Understand how the calculation works and the components that make up GP.
- Improve your GP. Build a team and process to focus on increasing gross profit.
- Love your GP. Give it extra time and attention. Sales are critical, but gross profit needs your love just as much. Remember, this is the only portion of the sale we get to keep. It’s up to us to make the most of it.
Know your GP: Understand How to calculate gross profit
The basic equation: Sales minus Cost of Sales equals Gross Profit.
Sales show up first on the income statement, followed by the Cost of Sales. The sale is the amount on the customer invoice. When the product is delivered and signed for, the accounting magic happens and turns the transaction into a sale. The sum of all the customer deliveries makes its way into the sales line on the income statement.
The cost of sales typically includes three things: cost of the product, freight cost to get the product to your warehouse and the alcohol taxes due on the sale. The route accounting system tracks the costs associated with each product in your inventory records. This cost is then calculated on every sale, and rolled up into the Cost of Sales on the income statement.
The difference between sales and cost of sales is your gross profit.
Gross profit is shown on the income statement in dollars and as a percentage of sales. Looking at GP as a percentage makes it easier to determine if you’re on track with your profit plan. For example, if your planned GP is 25%, and the income statement shows you’re at 24.5%, you know you’re coming up short. The percentage is an easy number to communicate and track.
To improve your gross profit, begin by understanding how the calculation works. Teach your team so they understand as well – sales, operations, administration – everyone plays a role with GP. Once you understand how it works, you and your team have the ability (and responsibility) to improve upon the number.
Improve your GP
Once you understand the math behind the GP, you have the power to improve the number. But you can’t do it alone, you’ll need some help from your friends.
- Get buy-in from ownership: GP is #1
- Create the GP Review Process: The road map to GP improvement
- Establish the GP team: Leverage the collective wisdom of the team
Set the Tone from the Top: GP is #1
In many distributors, GP is not #1 on the priority list. It’s not even number 2, 3 or 4. It usually falls somewhere after sales growth, out of stocks and out of code inventory.
The first step is to set the tone within your organization that improving gross profit is a key success factor for the business. Ownership and upper management need to wave the flag of GP, or the troops won’t get behind it. This sounds easy enough, but it won’t be if your company has always focused exclusively on sales growth.
The tone from the top has to be that gross profit is a priority, and everyone on the GP team will be expected to plan, prepare and participate in the gross profit meetings (more on this next). This will make it a lot easier to get buy-in from the sales team members who would rather be anywhere than in a gross profit review meeting.
I’ve seen it countless times, the review meeting is about to start and the sales manager has to make an emergency delivery to a customer. “I’ve got to deliver this umbrella or we’ll get kicked out of the account.” Set the tone that GP is #1. Deliver the umbrella after the meeting.
Create the Process to Review GP
The process to review gross profit can take many forms, but I’ve found it helpful to start with a look at the top line metrics. Keep things simple and focus on the numbers that matter most. Below is an example of how this information can be presented:
The Gross Profit Scorecard shows the total company GP % goal compared to actual results. It provides a starting point to discuss how the company goal was created – for example, use of historical trends, changes to product mix, etc. And it gives an opportunity for questions and discussion of the goal. At regular intervals back up and make sure everyone understands how GP is calculated.
After the top line numbers are reviewed, discussed and understood, it’s time to dig into the details of gross profit. Below are examples of reports to monitor and analyze GP results:
- GP by product line vs goal (beer, wine, non-alc if you have them)
- GP by supplier – actuals vs expectations
- GP by supplier, by brand, and by item if necessary
- GP by chain / independent
- GP by account
You can go as deep as you need to, but ease into it. It’s tempting to get lost in the details and start chasing a minor issue. Keep it top line to start, go after the big dollars.
Below are common issues to look for during the GP review:
- Is the pricing correct? Your sales or pricing coordinator usually has this stuff memorized. Are there any obvious errors (pricing that didn’t get input into the system)
- Are the costs correct? Your inventory person knows this stuff. Cost components: FOB/product, freight, taxes. Is it complete and accurate?
- Are all the depletion allowances / supplier billbacks properly accounted for? I’ve seen this before where one person cuts a deal with a supplier to bill something back, but they don’t tell the person who actually inputs the deal in the system. All of a sudden you have a 10% GP when you should have 25%.
Establish the GP Team
Depending on the size of your company, the GP team should include at least one person from sales, inventory management, finance and operations. Each person brings different expertise and perspective to the work at hand.
Generally speaking, the sales guy wants to discount everything to increase sales – gross profit be damned. The finance guy doesn’t want to sell anything unless it meets or exceeds the gross profit goals. The inventory and operations people just want to know which numbers to put in the system – they don’t usually have a dog in the fight. Despite these differences, it is the diversity of expertise and perspective that will ultimately yield a great result. It won’t always be easy, but opening up communication, educating the team, and focusing on a common goal will be a win for your gross profit.
In our company, we had the following people on the GP Team:
- Finance / CFO: lead the team, ensure everyone understands how the numbers work
- Inventory manager: review product costs for completeness and accuracy
- Sales manager / pricing coordinator: review pricing, discounting, for accuracy
- Operations / GM: implement changes needed to achieve GP goals
First and foremost, the GP Team exists to monitor, manage and improve gross profit. Despite the obvious differences in roles, responsibilities and agendas, the team must focus on a single mission: to improve gross profit.
The team should assemble on a regular basis for the GP meetings and follow the GP Process as established above. Below are GP meeting best practices:
- Meeting basics. Nobody likes long, drawn-out, pointless meetings. So don’t have those. Follow the meeting basics: begin and end on time, send an agenda well in advance, and meet to make decisions and take action.
- Take meeting notes and distribute to the team. Write it down or it didn’t happen.
- Plan and prepare in advance of the meeting. Run reports that need to be run, review them, come prepared with insights and action items to share.
Love your GP
The sales line gets a lot of attention, but gross profit needs your love just as much. This is the only portion of the sales dollar we get to keep, so it’s up to us to make the most of it. Give your gross profit the time and attention it deserves and you will see the benefit on your bottom line.
In future articles, I will explore available software options to improve GP management. Technology is great, but for now stick to the old school pen and paper to map out your GP game plan: educate your troops on how gross profit works, establish a process and a team to improve gross profit, and repeat. As Bill Gates said, if you use technology to automate a bad process you just make things worse faster. Get that process right and get it down on paper.
Every number on the income statement is important, but few numbers are as key as your GP. Sales are for the supplier, and gross profit is for you, the distributor. Focus on GP, use the three steps outlined here, and improve your GP today.