Gross margin, not turnover: how much must you sell?

Turnover is the number people boast about; gross margin is the number that pays the bills. Street Smarts' key-number idea applied to traders and manufacturers, with the simple arithmetic of overheads, discounts and new hires.

Ask a business owner how big their business is and most will give you their turnover. In his Inc. columns, Norm Brodsky, co-author with Bo Burlingham of Street Smarts, says that is the wrong number to watch. The number that matters is gross margin. The book makes the same point early on: the higher your gross margin, the fewer sales you need to cover your expenses, and the longer your starting money lasts. It also explains why a new business usually needs a niche: it can’t beat established players on price, and it needs good margins to survive. (See idea 2 on our Street Smarts page.)

This article shows, with hypothetical numbers, why the same turnover can mean very different businesses, and how to use gross margin to make everyday decisions.

The words

Gross profit is sales minus the cost of the goods you sold (for a trader, what you paid for them; for a manufacturer, material, direct labour and other direct costs of making them).
Gross margin is gross profit as a percentage of sales.
Overheads are the costs of running the business that don’t rise with each sale: rent, salaries, interest, electricity for the office, and so on.

Gross profit has to pay for all the overheads. Whatever is left is your operating profit. (This is close to the idea of contribution and break-even, which also takes out other costs that rise with each sale.)

Same turnover, different businesses

Hypothetical Two businesses with ₹1 crore of turnover

A distributor at a 6% gross margin: ₹1,00,00,000 × 6% = ₹6,00,000 of gross profit a year
A small manufacturer of its own products at a 30% gross margin: ₹1,00,00,000 × 30% = ₹30,00,000
The manufacturer has ₹30,00,000 − ₹6,00,000 = ₹24,00,000 more each year to pay for overheads and leave a profit

Neither business is better on this alone. The manufacturer probably has higher overheads (a factory, machines, more staff) and more money tied up. But the comparison shows why turnover by itself says so little: the distributor must run on a far smaller sum.

How much you need to sell

The simplest use of gross margin is to work out the sales you need just to cover your overheads:

Sales needed = overheads ÷ gross margin

Hypothetical Overheads of ₹90,000 a month

At a 12% gross margin: ₹90,000 ÷ 12% = ₹7,50,000 of sales a month
At an 18% gross margin: ₹90,000 ÷ 18% = ₹5,00,000 of sales a month
Six points more margin means ₹7,50,000 − ₹5,00,000 = ₹2,50,000 less to sell every month

For a trader, a few points of margin can come from buying better, choosing products and customers with better margins (see knowing your numbers by product and customer), or charging properly for credit and delivery.

What a discount really costs

A discount comes straight off gross profit, because the cost of the goods doesn’t change. With thin margins, small discounts need a lot of extra sales to make up.

Hypothetical A 5% discount at a 25% margin

A product sells at ₹100 and costs ₹75. You sell 1,000 a month.

Gross profit now: 1,000 × ₹25 = ₹25,000
With 5% off, the price is ₹100 × 95% = ₹95 and gross profit per unit is ₹95 − ₹75 = ₹20
Units needed to keep ₹25,000 of gross profit: ₹25,000 ÷ ₹20 = 1,250
That is (1,250 − 1,000) ÷ 1,000 × 100 = 25% more units, for a 5% discount

This is why the book warns against discounting just to fill spare capacity (idea 11), and why our discounts refresher is worth a look before you agree to one.

What a new hire really costs

Every new rupee of overhead needs many rupees of sales. Working this out before you hire, or before you take a bigger shop, is a quick reality check.

Hypothetical A new salesperson at ₹25,000 a month

Extra sales needed each month just to pay the salary:

At a 12% gross margin: ₹25,000 ÷ 12% = ₹2,08,333
At a 30% gross margin: ₹25,000 ÷ 30% = ₹83,333

The hire may well be worth it. The point is to know the number before you hire, and to check after a few months whether the new sales are there.

Watching it month by month

Brodsky’s advice, in his column on following the numbers, is to track monthly sales and gross margin yourself, by product and by customer, especially in the first year or two. Some practical habits:

Work out gross margin every month, not just at year-end. If your accountant gives you only yearly figures, do a rough monthly version yourself from purchase and sales registers.
Look for the products and customers that drag margin down. Big orders at thin margins can look like growth while adding little gross profit (see idea 7).
Know the sales you need. Divide this month’s overheads by this month’s gross margin and put the number where you see it every day.
For manufacturers, check margin by product line. Material price changes, rejections and price-downs can quietly cut margin on one product while the factory looks busy. See unit costing and capacity and yield.

In short

Turnover tells you how much passed through your hands. Gross margin tells you how much you kept to pay the bills.
Sales needed to cover overheads = overheads ÷ gross margin.
Discounts and new overheads need far more sales than they seem to. Do the sum first.

The ideas are Norm Brodsky and Bo Burlingham's, from Street Smarts and Brodsky's Inc. columns "Secrets of a $110 Million Man" and "Follow the Numbers". The explanation and the examples are ours.