If we can’t produce enough dollars of gross profit from our business, we are never going to produce the amount of operating profit we want or require. Yes we can cut fixed expenses, but we can only do that to a certain point, then it will impact on our ability to earn revenue which in turn will impact on our ability to produce the required amount of gross profit.
So it would seem then that in the P & L at least, gross profit is king, and the amount of operating profit we can generate will be determined by it.
In the new global economy with unlimited access to information, business is getting more competitive by the day, and will continue to do so. I am definitely seeing at the moment that the pressure is really on to maintain gross profit margin (%). There are a number of reasons for this so let’s work through them, then you can consider each one within your own business, whether it’s a problem, and what to do about it.
I have split this discussion into two areas, namely impacts on gross profit and or GP margin as a result of labour issues, and then materials issues.
Here we go, not in any order.
1. Materials cost increases not being passed on.
This can occur as a result of increases from local and international suppliers or unfavourable changes in the FX rate or freight for imported materials. Ensure where possible that these increases are being passed on to your clients or customers. Not easy to do sometimes I know, but search for and implement price rises for those services or products where you can. Alternatively search for other suppliers that have trading arrangements
suitable for your business, including lower pricing for materials of equivalent quality.
2. Product mix
Every business should review their financial statements at least monthly. If you do you will likely notice fluctuations in GP margin from month to month which can be caused by the mix of products or services you have sold for that month. For example a motor body builder may do more jobs during the month which have significant third party components such as cranes and toolboxes. These jobs will likely be higher sales value jobs but lower GP margin jobs. Also, quite often a higher value job will need to be priced keener to have a chance of winning it.
Set your minimum GP margin for that job that you know will contribute to producing the overall gross profit dollars required for the month, and don’t go below it.
3. Theft of materials
Not a particularly pleasant thought that one of our employees may be lifting stock, but nevertheless it happens. Put in place good systems, recruitment processes, culture development programs and CCTV if you think you need to.
4. Inadequate goods inward process
I have come across businesses’ that have paid significant amounts of money to suppliers for materials that were never actually delivered by the supplier. One of the quickest ways to lose money but one of the simplest to fix. Ensure you have someone with a detailed personality type responsible for goods in, and then put in place a robust process for physically checking inbound materials against the supplier delivery docket and invoice, for every delivery.
5. Materials used but not allocated
Common in manufacturing businesses where jobs are quoted that include a set quantity of materials, and then extra materials are used on the job but not allocated to the job card. Quite often this is due to worker mistakes which require extra materials for rework, for which they often don’t tell anybody. It can also happen as a result of materials being omitted in the original quote. Again having good systems for accurate quoting, good recruitment processes to recruit quality staff, and good staff training and mentoring will assist here.
6. High materials wastage
Can occur for a number of reasons including materials that are out of date, obsolete or damaged and hence unsaleable or unusable. It can also occur in manufacturing where cutting efficiency processes are not well defined or followed, or where materials wastage is not factored in sufficiently when quoting. Ensure you have good purchasing and warehouse processes to minimise the chance of ending up with unusable or unsaleable materials, and review your cutting and quoting processes.
7. Inaccurate stocktake / valuation method
When preparing management reports/financial statements the cost of sales (and gross profit) are impacted by the closing inventory balance. If the closing inventory balance is overstated the gross profit will also be overstated, and where inventory is understated the gross profit will be understated. Where a business doesn’t have a system in place to regularly manage stock control and valuation it is difficult to place reliance on the accuracy of the management reports.
8. Not correctly accounting for work in progress or progress claims
A manufacturing or project business needs to consider the impact of work in progress, progress claims and customer deposits when preparing its management accounts at the end of a month. The general principal is to match income and expenses related to each other in the same period. Subject to the requirements, this would involve calculating the WIP and removing it from the P&L until the job is complete or leaving the WIP on the P&L and accruing the income that relates to the job. When working through this process the impact of deposits and progress claims needs to be considered to ensure income is being recognised in the correct period.
9. Labour Calculation for Work in Progress
Following on from the above point the calculation of Work in Progress can is tricky one. While it can be simple to calculate the cost of materials for WIP, the cost of labour in not as straight forward. It is recommended the labour component for WIP includes – base rate, overtime, allowances, superannuation, work cover and payroll tax.
10. High rework or warranty work levels
I covered rework under materials but there is also a labour cost associated with rework and warranty work, insofar as it becomes an opportunity cost for the business because it ties up labour that could otherwise be spent working on other revenue and gross profit producing jobs. Again good recruitment, training, mentoring and systems will reduce rework and some warranty work. Also, if you a suffering a high level of warranty work then it is time to review warranty policies such as the warranty period, and have a deeper look at what is going on with quality.
11. Bookkeeping errors
Can happen a few ways. The first one can just simply be data entry (typo) inaccuracies into MYOB which inflate the cost of sales amounts, or in rare cases it could be supplier invoices for materials being paid twice. Ensure you have a really good, efficient bookkeeper, and that your accountant checks your accounting file monthly.
Similar to the discussion above on theft, we hope that our employees are trustworthy and share and live the core values of the business, however fraud does occur. A common fraud type that directly affects gross profit is a ‘billing scheme’. A billing scheme has three components; the creation of a false entity to receive payments, the creation of a false invoice or the falsification of a legitimate invoice to be submitted for payment, and the manipulation of the payments system so that the false invoice is approved and the payment is made. Talk with your accountant about implementing robust processes to avoid this occurring as it is pretty soul destroying when it does.
13. Low pricing
Usually the greatest source of low GP margin and occurs for a number of reasons including again, inaccurate quoting or incorrect or low charge out because the labour rate and materials costs are inaccurate. It also occurs as a result of discounting pricing to ‘win’ a higher volume of work, quite often by sales representatives in organisations where there is minimal policy and monitoring around pricing. Business is getting more competitive by the day. If you are caught up in a competitive price war, you have to understand if it’s short term only. If it is long term then you will need to review your business model, and quickly.
14. Employee productivity
Productivity is the amount of output relative to the amount of input. Low employee productivity can be caused by factory lay-out (no lean principles in place to create time efficiencies), low employee skill level and experience, and general distractions such as too much socialising on the job. The effect of this is that the variable labour expense relative to revenue will higher, reducing GP. This will also occur if you don’t keep the work (sales) up to them as quite often a business can’t reduce its skilled variable labour component to match work demand. It will also occur if too much overtime is allowed. Work hard on reducing waste across the business by implementing lean principles, developing training programs and developing a culture of high productivity. One measure of employee productivity you can monitor each month is revenue divided by the number of variable labour hours.
15. Low labour rate charge out
Again when quoting you must ensure your hourly labour rate charge truly reflects your current variable labour cost situation. Review your costs regularly to ensure you accurately account for wages, work cover, super, payroll tax, average overtime, all award allowances, all types of leave, non-productive time, and an allowance for write off such as warranty and over-runs.
The speed of change in the new global business environment is really catching many well established, historically financially sound businesses off-guard. We see this in the press every day. If it doesn’t exist within your business, you need to develop a culture of change and innovation.
There is one question to ask yourself as you move into the planning phase for 2016 and that is ‘What immediate changes do I need to implement to ensure the sustainability and prosperity of my business in 5 years’ time’.
Raffino Business Solutions
We are proud to partner Marsh Tincknell to assist their clients in reaching their goals and attaining freedom. Please contact your manager at Marsh Tincknell on 3422 8000 to discuss how Raffino may be able to assist.