The below article was sent in our small business owner newsletter and due to the popularity, we’ve decided to create a permanent post on the topic. At the time of this writing, there was mass concern the US economy was heading into a recession. The topic of focusing on your gross profit is always important.
First let me say this. I’m not here to say a recession is or is not on the horizon – that’s an opinion and a widely ranging one at that.
I find it most productive (and successful) to stay focused on what you can control as a business owner. Know the rules you’re playing by and try your best to win the game. Stay nimble. One of the most important ways to focus on what you can control is to understand the numbers which steer your business, specifically your profit and cash flow.
I was on the management team of a young and growing technology services company during the 2007-2009 recession. We had just crossed $1M in revenue during 2006 with big expansion plans for a new key business unit.
Things were looking up and then at the end of 2007, the US economy entered a recession.
Just 6 years later, after experiencing profitable year-over-year growth uninterrupted by the recession, we had a successful sale of the business.
What was our formula for success in staying profitable and growth-focused during a recession? We were obsessed with managing our gross and net profit margin.
One of the main concerns in a recession is a reduction in your sales volume. Your gross profit margin is a key driver in your ability to withstand a reduction in sales volume if you were to suffer from one.
Additionally, keeping your fixed costs (payroll, marketing and general overhead) under control is the second key driver. Your gross margin and fixed costs are the two numbers which control your breakeven point – the point at which your sales need to be in order to not lose money.
Let me show you an example to illustrate these points.
On the left you see ‘Business A’ and on the right ‘Business B’.
Business A and B sell the same product or service at the same price and have the same monthly fixed costs. The only difference is A operates at 50% gross profit and B operates at 35% gross profit.
Business A makes $25,000 a month at 25% net profit. Business B makes $10,000 a month at 10% net profit. The difference in net profit is simply the difference in gross profit.
Business A needs $50,000 in monthly sales, or 100 sales transactions, to breakeven (meaning they make $0 in net profit).
Business B needs $71,429 in monthly sales, or 143 sales transactions, to breakeven. I know it’s simple math but that’s 43 more sales transactions needed than Business A before they start making any profit.
Now let’s pretend a recession, or any economic downturn for that matter, comes along and both companies see sales volumes drop by 25%. What happens? Who survives?
Business A is still making $12,500 a month in net profit which is a 17% net profit margin. That’s still a respectable profit margin by most standards.
Business B is barely breaking even, making $1,250 a month which is just 2% net profit. They’re now dangerously close to operating at a loss.
Business A could still lose another 25%, meaning they’ve lost half of their business, and still stay alive, just breaking even.
If Business B loses another 3% of business, they’re no longer profitable.
Let me say this again. Business A could lose HALF of their sales volume and still operate without a loss. Business B can only lose roughly 28% of their sales volume before losing money.
That 15% extra gross profit buys Business A nearly twice the ability to withstand a downturn, as Business B.
So, are you with me on seeing the importance of gross profit margin?
Which company is more likely to survive a downturn in business?
Business A…the one who was obsessed with managing and optimizing their gross profit margin.
Again, this all starts with having a solid understanding of the numbers which steer your business and a firm grasp on your gross profit and what’s impacting it.
If you struggle with this or have concerns about your business if you were to see a decline in sales, reach out. While I hope this is not a reality for any of us, those who prepare and get their financial health under control now will be better off for it later – recession or no recession. Click here to setup a short call to chat.