Analysts and business managers tend to focus on the bottom-line profitability of a company when evaluating its performance. However, a very important, but often ignored, metric is the gross profit of a business. A company must first earn an adequate gross profit from its core operations to have the funds needed to pay overhead expenses and produce a net profit.
The income statement of a company has three basic components: sales, variable costs and fixed expenses. Sales include all revenue generated from selling the products and services of the business. Variable costs consist of direct labor, materials used in production, shipping expenses and supplies related to manufacturing. Overhead costs are those fixed expenses that a business must always pay, regardless of the amount of sales or profits. Overhead costs include rent, utilities, administrative wages, insurance, postage, advertising and office supplies.
Gross profit is defined as total sales minus variable costs. This results in a dollar figure that must exceed overhead costs to produce net profit. Managers monitor the gross profit monthly to make sure that they are covering fixed overhead expenses; if there is a shortfall, they must make corrections to cover the deficit.
Gross margin, a variation of gross profit, is calculated by dividing gross profit by total sales and multiplying by 100. This produces a percentage figure that is used to compare the performance of one company against others in the same industry. A below-average gross margin indicates either a pricing problem or excessive variable costs. Monitoring the gross margin on a monthly basis enables managers to spot problems early and initiate corrective actions. Investors look favorably on companies that consistently produce above-average gross margins.
Break-Even Sales Volume
The immediate objective for any business is to generate enough sales and gross profits to cover fixed overhead expenses. This minimum sales volume is the break-even sales level. After covering fixed overhead expenses, each additional dollar from gross profit shows up directly in bottom-line profits. Conversely, any sales volume and gross profit less than the break-even point will result in a loss. Dividing the break-even sales volume by the average individual unit sales price gives a manager the number of units that must be sold to reach the break-even point. This minimum amount of unit sales is assigned to the sales staff, and becomes their individual minimum monthly and annual sales goals.
After a manager has determined his break-even sales volume, he identifies how much he wants to make in profits and calculates the number of units that must be sold to reach this goal. These additional unit sales plus the minimums already established become the goals for the sales staff.