Gross Profit Analysis to Boost Business Performance and Enhance Decision-Making – 2 Case Studies 

Introduction – Using Gross Profit Analysis to Boost Business Performance and Enhance Decision-Making

If you want to grow a business, you need to pay attention to financial metrics – specifically your Profit & Loss Statement, and of all the separate measures on a P & L, Gross Profit is the most important, period.

Even if you’re not interested in growing your business, you need to understand if the amount of Gross Profit (generated by your business) is enough to cover (pay for) the remaining expenses in your business. You cannot sustain a small business if you operate at a loss for very long. If this creates no interest for you, you probably consider your business to be a side-hustle or hobby, so this post is not for you.

This post is targeted to business owners that are trying to grow a business.

Why is Gross Profit the most important measure? Because it’s a measure of the profit generating capability of your business. Not necessarily cash generation, but profit.

Every business involves activities that are required to generate a profit. These activities can be modeled. Two companies (competing against each other) for the same customers in the same geographic market, can have different business models (a collection of different activities, fewer or more activities or a different sequence of the same activities) that define how the business earns a profit.

If one company can produce and sell each unit of product, requiring fewer activities, or a simplified manufacturing process to produce/sell (with no loss in product quality or performance) this company is said to be more efficient. Similarly, a company that can complete and deliver jobs, faster with comparable quality, is also said to be more efficient.

Gross Profit is a reflection of time – how quickly a business can utilize and manage all activities involved from the time an order is placed to completing a sale. Gross Profit also reflects the amount of effort – the amount of direct expenses required to transform an order to a completed job or product and complete the sales process. The quicker a business can realize a sale through streamlined processes or better ingenuity and know-how with less effort – reduced direct expenses, the more likely this business will realize better performance through increased Gross Profit.

Gross Profit can also be used as a tool to enhance decision-making (toward improving profitability and value) under what-if scenarios such as, to buy or make a component or to add labor versus adding machinery – see Case Studies #1 and #2, presented, below.

How is Gross Profit Measured? 

Gross Profit is the difference between sales, either on a per unit basis (if you make a product) or the selling price per job (if you deliver a service) and direct expenses. If you manufacture and deliver a product, you want to know how much your per/unit selling price exceeds your per/unit expenses to manufacture and deliver (1) unit of product to your customer. Per unit expenses are usually detailed in a bill of material or BOM.

If you sell services, direct expenses are those that are required and are easily tied-to or associated with a specific job. If you have a construction business, direct expenses include, labor (contractors or employees), material (including indirect material like adhesives, where consumption/usage is not usually tracked), any equipment rentals, job supplies, and other costs or investments required to complete each job.

Sales, Expenses, Net Income and Gross Profit Defined:

• Net Income involves expenses “below” the Gross Profit “line,” which is a separate topic.
• Gross Profit is calculated “above” the line, where I’m defining the line as the Gross Profit amount.
• Net Sales = Gross Sales less discounts, returns, and other adjustments.
• Direct Expenses are those costs that are required to complete/manufacture/deliver each unit of product or service.
• Gross Profit is the difference between Net Sales and Direct Expenses.

Gross Profit Case Study #1 – John’s Guitar Emporium:

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John’s Guitar Emporium – Make vs. Buy Decision – Evaluation:

This is a fairly simple make vs. buy decision to either machine an emblem/logo for John’s GS-style guitars in-house or buy the finished emblem/logo from a supplier.

The first two “boxed’ statements for Sales and Direct Expenses are shown as a memo, only. With the exception of Sales volume, the figures shown in these boxes are not relevant to the make vs. buy decision.

The focus of this Case Study is the last box – Decision Table – Relevant Per Unit Sales and Expenses to Machine & Finish Emblem In-house or Buy Finished Emblem. 

At first glance it appears that the make decision would be the easy choice. However, to pay for the used CNC machine, fixtures and tools, the Gross Profit to machine and finish the emblem in-house must be greater than the Gross Profit to buy the finished emblem over the projected Sales volume. The difference in Gross Profit for the 1st year = $86,519 (Make) – $64,404 (Buy) = $22,115.

The increased Gross Profit of $22,115 (for the 1st year – 2025) to make the emblem/logo is used to pay down the cost of the used 3-axis CNC machine, fixtures and tools (loan principal = $132,000) + $77,327 total interest expense for a 10-year Note Payable at 10% – total cost of investment = $209,327. Under this scenario and using a simple payback period method, this means that it would take approx. 9 1/2 years to payoff the cost of this investment. Net Present Value and Internal Rates of Return calculations are also projections. To simplify the decision-making criteria of this study, a simple Payback period will be used.

If the total amount of the investment ($132,000) is financed, a 10-year, 10% Note Payable would mean monthly payments of $1744.39 or $20,933 for the year. This is just under the $22,115 Gross Profit benefit for the make in-house scenario. Obviously, the 1st year projection would need to be extended out for the next 9 years to assess the risk if 100% of the cost is financed and no other payment sources are planned to pay down the principal.

Some Facts:

• A used 3-axis CNC machine could last 20-30 years with proper maintenance and refurbishment.
• The benefit of making the emblem/logo in-house is derived from the lower direct costs to machine and finish and the projected Sales volume.
• This projection (like all projections) and the decisions that result is only useful and relevant if the figures are as accurate as possible.
• Setting aside any financial analysis, John’s may simply want to make the emblem/logo in-house to better protect their mark/logo from any unauthorized use of the look or design.

The decision to make in-house or buy depends on the answer to these questions:

• What is the expected Sales volume for GS-style guitars for the next 9 1/2 years?
• If the GS-style guitar is not expected to remain in production for at least 9 1/2 years, or if Sales are expected to decline significantly, is there an option to re-purpose the CNC machine, fixtures and tools to machine and finish a different emblem/logo for a different style guitar at John’s Emporium?
  • If the machine, fixtures and tools are to be re-purposed for a different style emblem/logo for a different guitar, what is the cost to re-purpose and the projected Gross Profit for the re-purposed use?
• Does the Payback period extend beyond the time that requires the machine to be refurbished?
  • If so, the cost to refurbish the CNC machine will need to be included in an updated projection of Gross Profit.
• What is the cost to refurbish the CNC machine?
• When (what year) is it expected that the CNC machine will need to be refurbished?
• What is the expected remaining useful (not based on depreciation, but the economic useful) life of the CNC machine after refurbishment?

Gross Profit Case Study #2 – R & R Construction, Inc.  

(Under Construction)