Most sales professionals have an understanding of how to calculate gross profit, but few understand the impact the daily cost of money has on a company's finances. To them, the gross profit calculation may simply involve taking the sell price minus the total costs. However, for the business owner, equally important is the cost of money and how long it takes a customer to pay their invoice. In fact, the two biggest impacts on a product's gross profit is the cost to finance inventory and the costs to finance receivables. These two factors play an extremely important role in determining the real gross profit on a given sale, and the true value of the customer account.
What is the gross profit on the sale?
When you sell a product or service, your gross profit is determined by taking the total sell price minus the costs of goods sold, often referred to as COGS. This is made up of product costs, freight costs, and other costs directly related to the sale of the product or service. For example, if you were to sell something for $30,000.00 and your total cost was $27,000.00, you would make a gross profit of $3,000.00 or 10%.
We won't look at the net profit calculation. Calculating net profit is done after determining gross profit. Net profit is your gross profit minus all your overhead, and other costs. Our focus will be on what the real gross profit of a given sale is once we take into consideration the cost of money, and how long it takes the customer to pay their invoice.
You can learn more about the cost of money by going to: Cost of Capital, Cost of Borrowing Money and Your Bottom Line
As a business owner, you most likely pay interest on money loaned to you by a bank or other financial institution. The interest rate is calculated on a daily basis. For sake of simplicity, let's assume your yearly interest rate is 5%. Your daily interest rate would be this 5% divided by the 365 days in a year. This calculation will provide you with a daily interest rate of 0.0137%. While it doesn't sound like much, this interest rate adds up every day it takes your customer to pay their invoice.
When a customer takes too long to pay, it directly affects your gross profit on that particular sale. Most of your customers will have 30 days to pay the invoice for the products they purchase from your company. Referring to our previous example above, we will assume your costs on a given sale is $27,000.00 and your sell price is $30,000.00. You will use money to finance the $27,000.00 costs of the sale. Every day the customer's invoice is not paid, it costs your company 0.0137% times this cost. This calculation gives a total of $3.70 a day in interest charges. This doesn't sound like much, but if your customer takes 45 days to pay the invoice, this amount quickly becomes $166.44.
The total cost to the company is calculated by taking the number of days your customer takes to pay the invoice, multiplied by the daily cost of money. In this case, it is simply the 45 days multiplied by the $3.70 daily cost of money. The step by step process is summarized below.
"Sorry, but I was told there would be no math!"
- Interest rate on money: 5%
- Days in a year: 365
- Daily interest rate: 0.0137%
- Total cost of goods sold (COGS): $27,000.00
- Daily cost of money: $3.70
- Days to pay invoice: 45
- Total cost to the company: $166.44
The perceived gross profit calculation seems rather easy.
The initial formula was a simple calculation where we took the sell price minus the COGS. In that case, the formula was very straightforward. However, the simple formula doesn't take into consideration the daily cost of money, or how long it takes the customer to pay their invoice.
What is the real gross profit of the sale when taking into consideration the daily cost of money, and how long it takes the customer to pay?
The actual gross profit of the sale is far more involved. The simple approach assumes there is no time between delivering the product and getting paid. Essentially, your customer would pay in advance or pay upon receiving the product. While some customers may have to prepay, most of your accounts will have up to 30 days to pay the invoice. We must take into consideration the daily cost of money, and the number of days it takes the customer to pay the invoice. The proper calculation takes the gross profit and minuses the 45 day cost to finance the invoice.
Since the total cost to support the invoice is $166.44 over 45 days, this amount must then be deducted from the $3,000.00 gross profit. This provides a new gross profit amount of $2,833.56 or 9.45%.How many of your customers take more than 30 days to pay their invoices? Every day an invoice is not paid, there is a cost to your business. This is not to imply that you force all your customers to pay up front, or pay faster than 30 days. This is simply not possible. You would not have any business if you insisted that all your customers prepay. However, what it does imply is that you take this into consideration when analyzing the gross profit on a given sale, and especially when you need to determine a customer's true value.
In the example above, we showed what it costs your company when a customer takes up to 45 days to pay an invoice. How does this compare to a customer who pays within 30 days on every invoice? Without having to go into to great a calculation, it is simply the difference of 15 days multiplied by your $3.70 daily cost of money. Doing this calculation shows that when a customer pays within 30 days, as opposed to 45 days, it saves the company $55.50 in receivable financing costs.
If you were to take this a step further, and analyze all your accounts, you would begin to see where all of your value lies. Sometimes the biggest account is not always the best client if they take the longest to pay their invoices. The goal here is not to isolate those accounts who don't pay on time, and sever the relationship. Rather, it is to take the time to understand what these costs are and how they, and the daily cost of money, affect your gross profit per sale.
The above video explains the differences between financing through a bank and financing with receivables factoring. You can learn more by going to: Sample Receivable Factoring Excel Sheet: Effective Rates & Interest Rates