We are continuing the series on business management basics. Last week, we looked at a 5-step approach that can be used to:
- get an overview of all your expenses
- divide them into direct and indirect costs and
- take action and reduce your expenses so that your profitability increases.
The week before that, you used your business data (or your best guess) to calculate your sales estimate for the coming year. Today, we are going to put the 2 together to calculate your gross profit margin.
More small business advice
Your gross profit margin tells you whether the products you are selling are covering the cost of buying or producing those products. Meaning: your selling price should cover your direct costs. Reminder: your direct costs are the expenses that you incurred to produce your product. If your selling price cannot cover your direct costs, your business is not commercially viable. More importantly, unless you take action to change this situation, it will never be.
How to calculate cost of goods sold for a small business
To calculate your gross profit, you need to know the actual cost of what you are selling. This is called Cost of Goods Sold (COGS).
- If you are a retailer, your Cost of Goods Sold is the price that you pay to your supplier plus the cost of transporting those goods to your business.
- If you are selling services, your Cost of Goods Sold will include your billable hours and anything that you had to buy specifically to carry out this particular contract. If you have to travel specifically for this contract, you will also include those costs.
- If you are a manufacturer, your Cost of Goods Sold will include your raw materials, any transportation expenses for those materials, the salaries of your production workers, and rent plus utilities of your production facility.
Your COGS does not include things like marketing, phone expenses or salaries of administrative staff or salespeople. These are part of your indirect costs.
For example: you have a bakery selling bread and pastries. You have 1 person in the shop helping you to bake. You also have 2 people going around selling your products. To calculate the COGS for your bread and pastry products, you will include:
- the cost of the ingredients that you need to produce your bread and pastries. Like flour, eggs, butter, vanilla extract, sprinkles etc. as well as any transportation cost to get these ingredients to your bakery
- the salary of the person helping you to bake the goods because this is also a direct cost.
You will not include the salaries of the salespeople because this is and indirect cost.
If you are a retailer, you will look at the price of buying the products you sell. Let us say you buy 1 pack of tea for €3 and you pay €0.25 for transportation to get it to your place of business. Your COGS for the pack of tea is €3.25.
If you have a bigger manufacturing business, you will also need to include any shipping and storage costs for raw materials, as well as production facility expenses. If your business is at this level, and you want some advice about how to calculate your COGS, please feel free to contact me.
Note: if you need a reminder of how to distinguish between direct and indirect costs, see the post that I wrote last week.
Another way to calculate COGS for a small business
It is important to know whether each of the products you are selling is making a profit. But sometimes it can be hard to calculate the COGS for each separate product that you produce. For example: a bakery will manufacture many different breads and pastries from one bag of flour.
Instead of calculating the COGS for each piece of bread or pastry, they can use another way.
At the end of the month, add up the following:
- the value of your beginning stock of products
- the value of the goods that you manufactured
- any transportation expenses for these goods or raw materials
- any salaries paid to produce these goods
- other direct expenses
Then subtract the value of your remaining inventory at the end of the month. The result is your COGS.
- on January 1st, you had breads and pastries in stock with a value of €100
- during the month of January, you produced breads and pastries equalling €500
- transportation for the ingredients was €50
- you paid the person producing the breads and pastries €150
- you had other direct expenses equalling €25
- on January 31st, close of business, you had breads and pastries with a value of €125 remaining in stock
- meaning that your COGS will be €700 as per the calculation below.
|Value of beginning stock||€100|
|Value of goods purchased or manufactured||€500|
|Salaries (direct labour)||€150|
|Other direct expenses||€25|
|Value of ending inventory||€125|
|Cost of Goods Sold||€700|
Note: if you are a retailer, you can also use this calculation to determine the COGS for each of your products. For example: instead of calculating the COGS for each separate pack of tea, you can calculate it for all the packs of tea at the same time.
Small business: how to deal with foreign currency
If you buy in foreign currency and sell in your own currency, your COGS will be affected by exchange rate fluctuations. The same product may cost €7 today, €8 next month, and €5 by the end of the year. If you do not take account of this in your selling price, you may find out that your business is losing money. If you keep changing your prices according to the exchange rate, it may cause customers to stop buying from you.
Here again, data from previous years can help you gain a competitive advantage. If you record data about the exchange rate, it will tell you:
- how the exchange rate develops throughout the year. You will start recognising patterns.
- what average exchange rate to use in your calculations.
When you use an average exchange rate in your COGS, you can set a fixed selling price. Using a fixed price means that sometimes your profit will be higher and sometimes it will be lower. It will allow you to only change the price if the exchange rate fluctuations are more than expected.
This may encourage more customers to do business with you because they know that your prices hardly change. Of course, as a business owner, you should not only compete on price. Try to find ways to increase the value of your products.
Calculate your small business gross profit
After you determine your COGS, subtract it from your sales.
So, taking the same example from above: your COGS is €700. Let us assume that the total of your bread and pastry sales for that month came to €950. Your gross profit margin is therefore €250. This is great. Note: the gross profit margin is also called contribution margin.
Your gross profit (or loss) will tell you how each of your products is doing.
For example: as a retailer, you may find out that your actual COGS is €3.10 for a pack of tea, but you are selling each pack for €3. You are therefore making a loss of €0.10 on each pack that you sell. If you sell 500 products, your loss is €50. You need to take action. Either find a way to increase your price or find a way to reduce your COGS.
Note: selling a product at a loss does not always have to be bad. It may be that this product is what is bringing people to your business and when they come, they always buy additional products that have a profit.
It may also be that you are accepting the loss for the time being until you have built your brand and you have established a strong customer base. The main question is whether this is a strategic business decision that you made or whether it is something that is happening without you realising it.
If it is a business decision, then the loss should be compensated by other profits or savings. If it is something that is happening without you realising it, you need to take action.
The gross profit is what you will use to pay your indirect costs. If, after paying indirect costs, you are left with money, your business is making a net profit. If not, you are making a net loss.
Your net profit is the money that you can use to save, invest, or pay for personal and family expenses.
Don’t forget to join me next week. We will be putting everything together and calculating our net profit (or loss).