Accurately measuring metrics that correlate with growth and profitability are essential to ensuring the sustainable financial health of your business. But with changing business models and compressed production cycles, traditional metrics like earnings per share (EPS) or revenue growth are no longer adequate to give you a clear picture of your company’s financial wellbeing.
Home Depot, for example, experienced falling share prices over a five year period in the early 2000s. Despite poor stock performance, the market value of Home Depot’s debt and equity was $88 billion at the end of 2003. With $29 billion invested in operating capital, their market-value added (MVA) , which measures the difference between the market value of a Home Depot’s debt and equity and the amount of capital invested, was $59 billion. By this metric Home Depot was the second healthiest retailer in the country behind Wal-Mart.
In the same way that EPS can be a poor indicator of overall financial health, strong revenue growth does not always indicate higher profitability.
To get a more refined understanding of your business’s performance and the factors that contribute to or inhibit growth, you’ll need to peel the onion back a few layers.
These 6 KPIs can help you lay bare the realities of your business’s growth, or lack thereof, and help you improve your bottom line with superior business insights.
1) Contribution margin
Contribution margin represents the incremental money generated from each product or unit sold after deducting your firm’s variable costs. Calculate contribution margin by subtracting variable costs from sales revenue. To get a percentage, divide by sales revenue and multiply by 100.
Contribution Margin = ((Product Sales Revenue – Product Variable Costs Per Unit) / Product Sales Revenue)) x 100%
The equation intentionally leaves out operating costs so you can see how profitable individual products are. This metric can help guide your pricing strategy, product mix, advertising spend, and inventory planning.
Whether you are in the manufacturing business or operate an ecommerce store, with a fine-tuned contribution margin, you can look at profit and loss (P&L) on a weekly or even daily basis and use the results to create more accurate demand forecasts.
Emazing Group, a successful ecommerce solution for consumer lifestyle brands, has managed to do just this. Using a contribution margin dashboard with data from sales channels, gross margin, and variable expenses, their team can see how much money they make off each sale, after considering varying customer acquisition costs.
With this refined P&L information at your disposal, your team can make more informed decisions on marketing campaigns and promotions, as well as identify profitability issues and make timely corrective actions.
2) Gross margin
Gross margin is like contribution margin but on a macro scale. By taking into account the cost of goods sold (COGS), excluding overhead costs and taxes, it measures gross profit as a percent of gross sales. Essentially, this metric tells you how much profit you are making on each dollar of sales. It is calculated by subtracting the COGS from sales revenue and dividing that number by sales revenue. Multiply by 100 to get a percent.
Gross Margin = ((Sales Revenue – COGS) / Sales Revenue)) x 100%
The resulting value is a measure of how your cost of production or, COGS, relates to your revenue. A higher percentage gross margin means your business is getting better returns and will have more cash to cover fixed costs and add to the company’s cash flow. A low gross margin suggests the need to reduce the cost of production or to increase prices. A manufacturer, for example, may seek more favorable contracts with supply chain partners or reduce inventory management costs.
Remember, gross margin does not incorporate overhead costs, so it is not a true measure of your business’s overall profitability.
3) Gross margin return on investment
Gross margin return on investment (GMROI) is an inventory analysis that reveals how well your business is able to turn inventory investment into profit. This metric helps uncover strengths and inefficiencies in your inventory planning and can be applied to single product lines or overall inventory operations.
To conduct this analysis you must have already calculated two preliminary metrics:
Gross margin: A proxy for profitability, see above.
Average cost of inventory: How much you spend on inventory over a certain period of time.
Find your GMROI by dividing gross margin by average inventory cost:
GMROI = Gross Margin / Average Inventory Cost
The result indicates the amount of profit your business makes on each dollar of inventory investment. A ratio higher than 1 means you are turning a profit on those inventory investments, while a value lower than 1 means you are losing money.
Carefully tracking this metric can help you optimize inventory levels for each product line, improve regional placement and pricing, and gain insights to make timely markdowns to avoid dead inventory.
To get an idea of how you’re doing compared to your competitors, check your industry’s GMROI recognized benchmarks. For example, Retailowner.com is a great resource for a number of different retail verticals and their GMROI standards.
4) Customer retention
It’s a well-cited fact that it’s up to 5 times more costly to attract new customers than it is to retain existing ones — and according to Bain & Company research, a 5% improvement in customer retention can boost profits by more than 25%.
To maximize customer lifetime value and ensure you are on the path to growth, it’s important to keep tabs on customer retention.
Customer churn rate and repeat purchase ratio are two measures used across industries to determine retention.
Churn is the rate at which customers cease their purchases and relationship with your brand. Calculate your annual churn rate by subtracting the number of customers at the end of the year from the number of customers at the start of the year, and divide by the number of customers at the start of the year. Multiply by 100 to get a percent.
Annual Churn Rate = ((# of customers at start of year – # of customers at end of year) / # of customers at start of year)) x 100%
Some churn is normal and varies by industry, but in general, an annual churn of more than 5-7% is problematic and indicates issues with your buyer’s journey.
Repeat purchase ratio is the percent of customers that have returned for a second purchase and is a good indicator of customer loyalty. This is calculated by dividing the number of returning customers by the number of overall customers for a certain time period. Multiply by 100 to get a percent.
Repeat Purchase Ratio = (# of returning customers / # of overall customers) x 100%
Both of these metrics should be monitored at a frequency that coincides with your sales cycle. If your business model is based on monthly subscriptions, you should keep track of retention metrics on a monthly basis. If you sell products on a quarterly basis, refresh your metrics at that interval.
By keeping a close eye on retention metrics, you can zero in on which demographics are your most valuable customers and optimize your customer profiles and sales strategy accordingly.
Improving the customer experience is the primary way to boost retention. This may mean offering seamless online ordering, more robust after-sales support, or dedicated account managers. Invite your customers to participate in surveys or to provide feedback to find out exactly how to improve their experience.
5) Digital sales growth
While brick and mortar shopping still accounts for the lion’s share of purchases, online shopping and ecommerce continue to gain ground. Online sales are expected to grow 14.8% year-over-year, while brick and mortar sales are expected to remain steady at only 1.9% growth.
Whether you are a manufacturer selling products wholesale or a local retailer selling directly to consumers, it is vital you offer digital buyer journeys to keep pace with market demands.
To make sure you are expanding your digital footprint and capturing the market share available online, measure your digital sales ratio at regular intervals.
This is calculated simply by dividing digital sales by overall sales at your chosen interval.
Digital Sales Ratio = Digital Sales / Overall Sales
Like customer retention metrics, the frequency of your measurement should be based on your sales cycle and customer volume.
6) Employee productivity
As your business grows, once lean processes can become bloated and required labor hours are likely to increase. To make sure workflows are scaling efficiently with business growth, you’ll need to keep track of employee productivity.
The basic formula for employee productivity is total output divided by total input. Your output can be the number of units produced or the sales revenue generated over a certain period of time, while the input can be the number of labor hours or the number of employees utilized for that same period.
Employee Productivity = # of units products / # of labor hours
For example, say your company produced 100,000 units over a one week period, which required 2,000 hours of labor:
100,000 2,000 = 50
This means your company produced 50 units per hour worked.
Now, let’s say you want to measure productivity based on sales revenue per employee:
Employe Productivity = Sales Revenue / # of employees
For example, your company closed $200,000 worth of sales over a one week period utilizing 25 employees.
$200,000 / 25 = 8,000
This means $8,000 worth of sales value was generated per employee for that one week period.
For certain industries and job functions, such as customer service, there are recognized benchmarks for what qualifies as productive. However, in many cases, companies will need to monitor and establish their own standards for productivity excellence.
By monitoring productivity levels regularly over time, you can expose bottlenecks and inefficiencies that stunt profitable growth. If revenue and production volume are growing while productivity is decreasing, consider investing in more advanced software systems and automation to bring efficiency back to your processes. Processes that can benefit from automation include:
- Order management
- Inventory management
- Shipping and tracking
- Time tracking and payroll
- Expense and profitability reporting
By pairing your employees with the proper digital tools, you can ease the human resource burden of growth.
To reach your growth and profitability goals, you’ll need to look beyond your top and bottom-line numbers. Instead, identify and measure the financial and non-financial factors that contribute to those top and bottom-line figures. You can do so by regularly checking in on your:
- Most profitable products
- Gross margin
- Inventory performance
- Customer retention
- Digital sales growth
- Employee productivity
By keeping tabs on these six metrics, you can avoid the pitfalls of blind growth and guide your business to a more profitable bottom line.