Gross Margin: A Key Ingredient in Financial Planning
Financial Planning is the process of setting goals for profitability, asset management and cash flow. It starts with planning Revenue based on realistic assumptions for billable rates or sales prices. Revenue should be segmented by lines of business or product hierarchy to help with marketing and sales strategies. This allows analyzing revenue variances by volume and price for mid year corrections.
Gross Margin is a core profitability metric that depends on Cost of Goods (COGS). COGS represents the cost of delivering the Revenue plan. It includes product costs or direct labor costs, plus Overhead. Overhead covers the expenses that are not easily identifiable to any one cost objective, such as warehouse costs, freight, depreciation, or direct supervision. These expenses are spread across all products and services and are part of Cost Management.
Gross Profit (GP) is the difference between Revenue and COGS. Gross Margin (GP/Revenue) can be bench marked against historical trends and industry standards, and improved with a continuous improvement mindset.
The key steps for Financial Planning are:
- Create a detailed Revenue plan and compare it with monthly performance to get actionable insights for Marketing and Sales;
- Develop a realistic COGS plan that consists of variable costs (Direct Labor or Product Costs) and a detailed Overhead plan with stakeholder input;
- Review the Gross Margin plan and compare it with historical trends and industry benchmarks, and set goals to increase Gross Margin.
This establishes the Gross Profit pool to fund the Operating Expenses (Sales, Marketing, R&D, Distribution, etc.) and generate an acceptable Operating Margin. Then, the monthly review process begins. In our next post, we’ll discuss some details. In the meantime, if you need help with your Gross Margin plan, contact us.
