Top tip: Financial healthcheck # 2

10Feb11

 

By Ellen O’Hara

In the first post of this series we looked at assessing general financial performance, but how can we help plan better for growth? In the next two posts we’ll be breaking down profitability into bite sized chunks and de-mystifying the profit and loss account a little.

So to begin with you’ll need a profit and loss account, which your accountant will prepare if you use one. If not, have a look at our tips for putting one together.  There are also some great guidelines on the Business Link website.

You can put the profit you make into perspective by looking at various ratios, which compare profit as a percentage of turnover. The first useful ratio is the gross profit margin, which looks at gross profit as a percentage of turnover. Gross profit can be calculated by taking turnover and subtracting the cost of producing the work that has been sold. For a designer maker this will typically include costs such as materials, outworkers, packaging etc.

The gross profit margin is shown as a percentage and can be calculated as follows:

Gross profit margin = gross profit ÷ turnover x 100

A simple exmaple - if you had sales of £70,000 and the cost of producing the work sold was £30,000, you would have made a gross profit of £40,000 (£70,000 minus £30,000). So if you made a gross profit of £40,000 from sales of £70,000, the calculation for gross profit margin will be:

£40,000 ÷ £70,000 x 100 = 57%

This means that for every £1 of sales you make, profit after taking off the costs of production is 57p. As a broad rule of thumb, we should be aiming for a gross margin of around 60-70%. This should allow enough gross profit to cover all of our other business expenses.

Our research tells us that the average gross margin among designer makers here is 71%, which is good news. Designer makers that have low gross margins can still run financial sustainable businesses provided that they can produce and sell relatively high volumes of their work.  If this applies to you, you’ll need to consider whether there is a high enough demand for your work and whether you can actually produce in large enough volumes (or indeed want to!) to make it stack up financially.

If you want to improve your gross margin, you could consider increasing prices or looking for cheaper suppliers (or a bit of both!).  Or you might be able to increase the proportion of sales that you make through direct selling opportunities (which tend to be more profitable), and reduce the amount on SOR or wholesale trade that you do. Alternatively there may be opportunities for streamlining the designing and making process to see if you can make savings this way.

So what implications does your gross margin have for you? Are you performing well, or do you need to make some changes? Let us know how you compare.

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Tags: Finances, financial health check, profitability