More work came in. The team was busier. Sales increased. But the extra profit just does not seem to be there.
It is one of the more frustrating situations in business, and one of the first places I would look is gross profit margin.
What gross profit margin tells you
Take your sales and deduct the direct costs of delivering them — stock, materials, subcontractors, or other costs directly linked to providing the product or service. What is left is your gross profit.
Divide that by sales and you have your gross profit margin.
Gross profit ÷ sales × 100 = gross profit margin %
It tells you how much of every pound of sales survives the cost of actually delivering the work. Everything else — rent, salaries, software, your own drawings — has to come out of what is left.
What can happen over two years
Year one
Sales £200,000 · Direct costs £130,000 · Gross profit £70,000 · Margin 35%Year two
Sales £240,000 · Direct costs £168,000 · Gross profit £72,000 · Margin 30%
Sales increased by £40,000. Gross profit increased by just £2,000.
The business did considerably more work for very little additional gross profit. More invoices, more delivery, more risk, more management time — and £2,000 to show for it.
The number worth noticing
If the business had held its 35% margin, £240,000 of sales would have generated:
£240,000 × 35% = £84,000 of gross profit
Instead it generated £72,000. That is a £12,000 difference.
And you will never see a line in your accounts called “margin lost”. It does not appear anywhere. It simply is not there.
How margin slips without anyone noticing
It rarely happens in one dramatic moment. It happens like this:
- A supplier increases prices and the increase is absorbed rather than passed on
- A discount is given to win a job, then quietly becomes the normal price
- A project takes longer than quoted
- Labour or materials cost more than expected
- A customer negotiates terms that were never revisited
Individually, none of these looks significant. Together, they can quietly reduce your margin by several percentage points, and turnover growth hides it. That is why revenue on its own does not tell you enough.
Three questions worth asking
- Do you know your gross profit margin? Not roughly. The actual figure.
- Is it improving or declining? One figure is a snapshot. The trend is the information.
- Does it vary by product, service or customer?
That third question matters most, because an overall average can hide a great deal. A business can have one profitable service subsidising another that loses money on every job, and the blended margin looks acceptable. Splitting the figure out is often uncomfortable reading, and usually the most valuable thing you can do with it.
One practical caution
What counts as a direct cost and what counts as an overhead varies between businesses, and sometimes between bookkeepers. If costs move between categories from one year to the next, your margin will appear to change even though nothing in the business has.
So the most useful comparison is your own margin over time, calculated consistently. Industry benchmarks are interesting, but they are not calculated on your basis.
What to do with it
Calculate it monthly rather than annually. A margin reviewed once a year, when the accounts are prepared, tells you about a problem that started twelve months ago. A margin reviewed monthly tells you while there is still something to be done about it.
Once you know the figure, it feeds directly into your break-even point — because the lower your margin, the more you have to sell simply to cover the same fixed costs.
Regular management accounts make this routine rather than an annual discovery.
Growing sales is not necessarily the same as growing profit.
If you would like help working out your margin, or splitting it by service or customer, book a consultation.
