Are you selling yourself out of business? You may think that is a silly question. You have plenty of sales. You are seeing a steady growth in your sales numbers. Of course you are not selling yourself out of business. Or are you?
In reality, you may be doing it and not really realizing it.
Let's put it this way. What is your gross margin? Is it enough to pay your fixed expenses? What is the gap between when you pay for goods and when you get paid for those same goods by customers? If these numbers are off, you are literally selling yourself out of business.
Let's break it down.
What is Gross Margin?
Gross margin is the difference between the selling price of your goods and the cost of the goods sold. So, if you made $1000 in sales, but it cost $500 to buy the goods from your suppliers and sell them to customers, your gross margin is $500. That is the amount of money you have to pay fixed expenses with.
Why is the gross margin so important? You need to calculate how much you have to sell to cover all your fixed expenses. That gross margin tells you that critical number.
Variable Expenses vs. Fixed Expenses
You need to know the differences between variable and fixed expenses. They allow you to track the costs you can control and the ones that will vary depending on your sales figures.
- "Variable Expenses" are the ones that will change based on the amount of sales you're doing. Another term for this is "Cost of Goods." This number covers all the costs associated in producing a product or service. This includes the cost of materials and direct labor, along with shipping costs and sales commissions. One way to think about these costs is "Would I have incurred this cost if I did not make a sale today?"
· If you are a wholesaler, your purchase cost is your variable expenses as well as shipping costs and sales commissions.
· If you are a manufacturer, the costs of raw materials and labor to make the product is in the variable expenses, along with shipping expenses and sales commissions.
· For a service provider, the wages of those directly providing the service as well as the cost of supplies are part of the variable expenses.
- "Fixed Expenses" are the ones that do not change based on sales. A term you might hear used with this is "Overheads." Some examples of fixed expenses include rent or mortgage payments, utility bills, wages to administrative employees, and office furniture.
The "Cash Gap" is the time between when you pay for goods and when the customer pays for the same goods. For example, you paid for widget X on January 1. You sell widget X on July 1 for cash. Your cash gap in this case is 6 months. This is a very simple example, but gives you the idea.
Why is this important? You have tied up part of your cash in the purchase of inventory. You will not see that cash released until you receive payment from a customer's purchase of that inventory. If you tie too much of your cash into inventory and do not get cash flowing from sales, or you don't take into account that each time you sell your products you have to reinvest in additional product, you will see your operating funds dry up in front of your eyes.
What Does All of This Mean?
To be profitable, you need to generate enough sales to cover both variable and fixed expenses. Even more important than immediate profitability is cash flow. You need to sell enough to keep the cash flowing through your business.
How can you free up your cash flow and improve your gross margins?