Gross profit is a very important driver of your profitability. Healthy gross margins make it much easier to bring a solid profit down to the bottom line.
Revenue – cost of goods sold = gross profit.
Some, or all, of your cost of goods sold represents products you buy from suppliers and sell to your customers. In most cases, you initially bought these goods or materials and put them into inventory.
Later they became a part of a sale to your customer. At that point the cost of those goods and materials moved from inventory (on your balance sheet) to cost of goods sold (in your P&L).
You would be surprised how many business owners are making important business decisions based on what their P&L says about gross profit only to discover later that the gross profit number was wrong.
The revenue was correct. But the cost of goods sold was wrong.
And the error is almost always on the side of showing cost of goods sold that is lower than the real cost. The result is an inflated gross profit… and misguided decisions (especially about pricing).
One way to combat this problem is to:
Pay attention to your cost of goods NOT sold.
How? Begin paying very close attention to how much inventory is sitting on your balance sheet.
- How many days of cost of goods sold (Days of Inventory Outstanding, or DIO) are sitting in inventory?
- Is DIO trending up or down over the last 12 months?
- Get out and physically look at your inventory.
- Does it look old?
- Does your gut tell you it is being managed poorly?
What usually happens in a company is inventory slowly builds during the year. The slow or non-moving inventory gets pushed aside and ignored.
Management can't see the scope of the problem because they are focused on the income statement (the P&L) and not the balance sheet. They may be paying attention to cost of goods sold, but they aren't paying attention to the cost of what's NOT being sold.
They aren't paying attention to the inventory balance.
Eventually though, reality raises its ugly head and management does the work to dig into the inventory detail, figure out what's gone bad, mark it way down, take a big inventory write-down that flows through the income statement, then get rid of the old inventory in an attempt to salvage at least a little bit of the cash that was used to buy it originally.
There's a better way. Pay extra close attention to the inventory number on your balance sheet.
Don't allow your inventory balance to become a dumping ground for nasty financial surprises.
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