Have you ever wondered where the “bottom line” on profitability starts? It actually doesn’t start at the bottom. The “bottom line” starts up higher on the income statement with a healthy Gross Margin (GM) or Gross Profit Margin. Simply stated, GM is total sales revenue minus the cost of goods (services) sold, divided by the total sales revenue (expressed as a percentage).
(Revenue – Cost of Goods Sold (or GP)) / Revenue = Gross Profit %
It is a critical measure in any business. A healthy GM is the result of good decision making about the price and cost of your products or services. GM represents a key factor behind many of the most fundamental business considerations, including break-even sales, budgets, and forecasts. These decisions are significant for becoming and staying profitable.
So, what is the definition of “healthy” when it comes to GM? As a starting point, GM must be sufficient to cover all operating expenses such as selling, marketing, distribution, warehousing and administrative costs. GM must also adequately allow the business to realize the desired amount of net income or “bottom line” profit. If both are true, then GM is healthy.
GM percentages can vary widely depending on the industry served. In the distribution industry, 30% GM can be attractive. In manufacturing, there is often more internal control over costs, and margins above 40% to 50% are a reasonable goal. Service firms adding real value to client companies can also enjoy a high GM. No matter the industry, it’s important to know the industry average and seek to be at or above it. If the business has below industry average GM then their value equation is likely out of balance.
So what can be done to increase GM? Many levers exist to make this happen. The most obvious ones are increasing prices and reducing costs. Less obvious are managing the mix of products or services you sell to customers, taking advantage of early pay discounts if cash flow is sufficient, negotiating volume discounts, asking for volume rebates or other trade rebates on purchases, and periodically introducing profitable new products or services.
Many times uncovering opportunities to increase GM requires more in depth data mining and analysis. For example, a review of all items being sold at an average price generating less than breakeven GM is necessary. This analysis can reveal opportunities with certain customers or even help decide to exit or deemphasize unprofitable lines of business.
One real-life experience involved a retail establishment that used an inventory software system in addition to QuickBooks for their accounting software. Over time the actual inventory markup per items in the inventory system produced erroneous retail sales prices. As a result, actual GM averaged 10% lower than their expected margins (26.32% versus 36.86%). This error resulted in a “bottom line” loss of $400,000 on annual sales of $4,000,000.
As a B2B CFO®, helping clients improve GM is a role I play frequently and one that I enjoy. Having a healthy GM enables company leaders to focus on growing, not simply surviving. Even though one specific fix does not fit all companies, one or more of the possible actions discussed above can make an immediate impact on GM. If you would like to make sure that your business is at or above your industry average in GM and clear the path to reaching your targeted bottom line profit, please contact me.