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Here at Freshwater, we encounter many stressed business owners with healthy turnovers but weak cost of sales and bottom line profits. Turnover is often seen as a key indicator of success and while having a high turnover is certainly a positive sign, it’s definitely not the be-all and end-all. Without a healthy net profit and well-managed Cost of Goods (or services) sold, your business may survive in the short term, however, it will likely struggle to achieve long-term sustainability and growth.

Turnover / Revenue

Turnover is the total income generated from the sale of goods or services. High turnover indicates strong sales and market demand. However, it doesn’t provide a complete picture of financial health. You can have fantastic turnover, but if your expenses are equally high or higher, your business may not be profitable. Growing and strong turnover can be misleading and can even provide a false sense of security. Small business owners with quickly growing turnover are renowned for getting comfortable and assuming that higher turnover justifies the need for greater overheads. What can then happen is that when the business reaches a lull period or downturn, it’s revenue then can’t sustain the increased costs. As a business owner, if you notice that you are increasing your overheads, justifying this with your increased sales, be sure that you leave yourself room to be able to cut these additional expenses in quieter periods.

Net Profit

Net profit is your total profit after all expenses, including COGS / COS and operating expenses have been deducted from revenue. Net profit is the ultimate measure of a business’s profitability. It shows how much money the business actually retains after covering all costs. When analysing your business final EOFY net profit, be sure to remember that this figure should factor in depreciation on your assets where relevant.

Cost of Goods Sold (COGS) / Cost of Services (COS)

COGS are the direct costs attributable to the production of the goods or services sold by your business. This includes raw materials, labor, and manufacturing overhead.

In a service business, Cost of Goods Sold (COGS) is often referred to as Cost of Services (COS) or Cost of Revenue. COS includes the direct costs associated with delivering a service. Key components include: direct labour costs, materials & supplies, subcontractor costs, service delivery costs, equipment costs, other direct costs.

These costs directly impact your gross profit. Lowering these could significantly increase your gross profit margin, ultimately leading to a higher net profit.

Gross Profit Margin

Formula: (Gross Profit / Revenue) × 100
A higher gross profit margin indicates better efficiency in production and sales processes.Why? Because this means that gross profit is closer to total revenue, meaning that a business is well able to manage its direct costs.

Here’s why both Net Profit and COS / COGS matter the most:

Sustainability: A business with high turnover but low net profit may struggle to sustain operations in the long run. High expenses can easily start to erode profits, making it difficult to reinvest in the business or weather financial downturns.

Cash Flow Management: Net profit directly affects cash flow. Positive net profit ensures that the business has enough cash to meet its obligations, invest in growth opportunities, and provide returns to shareholders.

Investment and Growth: Investors and lenders look at net profit and gross profit margins to assess the viability and growth potential of a business. A business with strong profitability metrics is more likely to attract investment and secure financing.

Operational Efficiency: Managing COGS effectively can lead to better operational efficiency. By reducing waste, negotiating better supplier terms, and optimising production processes, businesses can lower COGS and improve profitability.

Strategies to Improve Net Profit and Manage COGS

Cost Control: Regularly review and control operating expenses. Identify areas where costs can be reduced without compromising quality or customer satisfaction. Consider pausing subscriptions that you don’t need during quieter periods.

Pricing Strategy: Implement a pricing strategy that reflects the value of your products or services. Ensure that prices cover COGS and contribute to a healthy gross profit margin.

Supplier Negotiations: Negotiate better terms with suppliers to reduce the cost of raw materials and other direct costs. Consider bulk purchasing or long-term contracts for better rates.

Process Optimisation: Streamline production and operational processes to reduce waste and improve efficiency. Invest in technology and training to enhance productivity.

Product Mix: Evaluate your product mix to focus on high-margin items. Discontinue or reprice low-margin products that do not contribute significantly to profitability.

While high turnover is a positive indicator, it’s really not enough to ensure the long-term success of your business. Focusing on net profit and effectively managing COGS / COS is the best way to build a sustainable and profitable business. By implementing strategies to control costs, optimise processes, and improve pricing, you can enhance your profitability and set the stage for lasting success.

Remember, a great business is not just about generating revenue—it’s about retaining profit and creating value. For help understanding your 2024 financial year P&L, or to enquire about our affordable virtual CFO program; don’t hesitate to get in touch with our team.