Gross Margin Profit Calculation

If you’ve taken our online Coordinator Course, you are familiar with the universal concept of a ValueHub™ and its Orchestration. However, to capture enough value to make a profit we’ll need to understand how to calculate performance and how much is needed to break-even.

First, let’s have a closer look at the ValueHub™ Orchestration (PDF):

ROUNDMAP_ValueHub_Orchestration

Although the figure is self-explanatory, it should be clear that -regardless if you begin with orchestrating demand or supply- you’ll need both to be able to capture any value as profit.

Universal Concept

The ValueHub™ itself is a truly universal concept. It describes how governments, businesses, universities, lecturers, students, family members, and dog trainers alike orchestrate the delivery of some kind of value to other ValueHubs to fulfill a want or need (economical, functional, environmental, social or emotional) at a profit.

ROUNDMAP_ValueHub_Universal

Cost-Volume-Profit Analysis

How do we know if our strategy is successful? Obviously, we need to know the cost (fixed and variable) involved in delivering value. Once we know this, we can calculate how much product we need to sell to break-even. Besides what revenue we should achieve (to break-even), we also want to measure our performance against what could be achieved (available market).

First, we need to know what our break-even point is. This can be derived from a Cost-Volume-Profit (CVP) Analysis. It looks at fixed costs, variable costs. sales price and sales volume to determine Gross Profit Margin.

CVP Formula: Break-even Sales Volume = Fixed Costs / (Sales - Variable Costs)

The two dominant variables that determine a firm’s performance are price and volume. Volume depends on the size of the market as well as the level of competition, while the price is relative to the maximum price a customer is willing to pay (= reservation price).

Performance

Let’s assume the fixed costs are estimated at 25.000 euro per year, while the variable costs are determined at 25 euro per sale. If we sell a product at a price of 50 euro, the break-even volume is 25.000 / (50 -/- 25) = 1.000 units (CVP Formula). If we set our price at a premium, i.e., 100 euro, the break-even volume is at ~ 333 units.

Now, let’s assume the reservation price is 110 euro, while the serviceable available market (SAM) is 2.500 customers (= reservation volume). SAM is based on a firm’s products and distribution channels. It represents the total revenue a firm could achieve if it had no competition.

We’ve decided on a pricing strategy, given our strengths relative to the competition, and sell the product indirectly, using our existing dealer network, at 75 euro. After a year we’ve sold 900 units.

We can now calculate the Gross Profit Margin (GPM) as well as our GPM Growth Potential:

Performance Analysis (75 euro/unit)

Available Market:

Serviceable Available Market (SAM) = 2.500 units at 75 euro/unit
SAM Revenue (SAMR) = 2.500 * 75 = 187.500 euro

Break-even Performance:

CVP = 25.000 / (75 -/- 25) = 500 units to sell to turn break-even

Reservation Volume Rate (RVR) = 500 / 2.500 = 20%
Reservation Price Rate (RPR) = 75 / 110 = 68%
Break-even Performance Rate (BPR) = 20% * 68% = 13,6%

Actual Performance:

Yearly Revenue = 900 * 75 = 67.500 euro (900 units sold)

Reservation Volume Rate (RVR) = 900 / 2.500 = 36%
Reservation Price Rate (RPR) = 75 / 110 = 68%
Actual Performance Rate (APR) = 36% * 69% = 24,5%

Gross Profit Margin (GPM) = 67.500 -/- 50.000 = 17.500 euro
GPM Growth Potential = 187.500 -/- 50.000 = 137.500 euro

With a Gross Profit Margin of 17.500 euro, there is a 137.500 euro Growth Potential left to develop (+785%). Obviously, costs vary depending on the business strategy (horizontal strategy, strategic partnerships, pricing strategy, distribution strategy, etc.), industry structure, level of competition, substitutes, and so on.

Those rather simple formulas demonstrate how we can calculate relative performance and perceive whatever is left to develop, given our current strategy. Even if we change strategy, for instance, bypass our dealer network and sell directly to end-users at a lower price, we can still compare relative performance year-over-year.

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