October 24, 2024
FundamentalsOS

A deep dive on Gross Margin

Topics:

We talk revenue. We talk profit. We talk cash.

But we're missing one of the other key metrics: Gross Margin.

Today we're going to dive deep into it and talk about the 4 drivers of it.

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A deep dive on Gross Margin

Have you ever walked into a situation confident only to realize you had no idea what you were doing?

When I came out of college, I ended up working

Early in my career, I jumped between a few bigger companies and realized that I didn’t enjoy being a cog in that wheel (control freaks unite!).

So, I started looking for jobs. I focused my search on small to medium businesses not really knowing what I was doing. But I did know that a pure accounting job at a bigco wasn’t for me. So I thought, by working at a smaller business, I’d get a wider experience.

Eventually an opportunity presented itself. A fast growing small business with an opening to lead a small accounting team where I’d also be in charge of IT and HR.

I was excited. There was an energy behind going into a situation and being “the man.” Sure, I didn’t know how to handle IT or HR, but I could figure it out. But I was the man.

It only took a few days to regret the desire to be the man. In my first meeting with the CEO, we’re going over financial statements. I’d spent hours upon hours examining them. I’d looked for trends and dug into accounts I wanted to understand.

I’d noticed a swing in gross margins, so I mentioned it to the CEO. He turns and asks “so, how do we fix it?”

In hindsight, I should have been prepared for that. But, yeah I absolutely wasn’t prepared. I froze. I started to talk… stammered… then froze again. As I restarted, I managed to stammer “well.. we could increase prices or decrease labor.”

I asked for some time to look into it and come back with a more concrete answer and he was gracious enough to grant it.

I don’t know if he regretted his decision in that moment, but I sure did…

I went away, came up with some more ideas, and we made a plan.

Over the next few months, we saw gross margins improve.

The ability to manipulate the numbers based on your direct action is essentially a superpower and I felt like superman.

Over the years in that position, that feeling never went away. As I’ve started my own business, I still feel that feeling.

But most business owners don’t know what to do. They haven’t gone back to the basics.

So, today, we’re going to go deep on gross margin.

What is it? How can we impact it?

Let’s dive in.

What is gross margin?

Gross Margin is the percentage of revenue money left after direct costs (or cost of sales/cost of goods sold) are accounted for.

Gross Margin is calculated by dividing Gross Profit by Revenue.

 

So, why does Gross Margin matter?

Well, let’s say you improve gross margin by 2.25% (right column). If General & Administrative costs remain the same, you’ve increased profit by 11.3%.

 

To get that same impact without a change to gross profit dollars, you’d need to decrease General and Administrative expenses by $22,500, or 6.43%.

Cutting $22,500 from an “overhead” is a one time cut as well, while you get benefits to changes in Gross Margin today and in the future.

Now, let’s take the other side of the equation… a 5% increase in Cost of Goods Sold expense would decrease profit by almost 10%.

 

This makes them extremely powerful and important to control.

Ok, I hope you can now see… it’s huge… it might be the most important number on your Income Statement.

So, how can we impact it? There are 4 main drivers of gross margin.

Drivers of Gross Margin

When we look at gross margin, there are 4 drivers:

  1. Price
  2. Cost
  3. Revenue Mix
  4. Operational Efficiencies

Price

Obvious, right? But what’s not so obvious is this: most small businesses do an extremely bad job raising prices regularly.

​Big businesses raise prices all the time​. But many small businesses struggle because of fear they’ll lose customers.

This has gotten better, as more small businesses have been raising prices. But what did it take? It took 71% of small businesses recording a 20% increase in costs, ​which was is what happened in 2022​.

Prices should be raised in 2 scenarios:

  1. Annual increases
  2. When price structure changes

By priming your customers for regular increases, you’re able to make small increases that generally won’t “shock the system.”

When a customer has the same price for 5 years, a change feels substantial. Override this instinct by making increases regular.

There are different strategies to deploy here.

  1. Annually increase prices on everyone
  2. Annually increase prices for new customers
  3. Annually increase prices on “non-core” customers

Which approach you take is dependent on the relationship you have with your customers. If you’re a high-touch service, annual increases may not ideal.

Like a landlord with a full rental, increasing prices could draw attention to a service they would have otherwise continued without question.

I wrote more in depth about this in August, posting ​16 signs your prices are too low​ and offering ​5 pricing strategies & a step-by-step process to raising them​.

Costs

Cost associated with revenue is tricky because if you could reduce costs you would have done it, right?

So instead of talking about “ask for a lower price,” let’s look at the other options.

  1. Look for new suppliers
  2. Take advantage of volume discounts
  3. Clean up non-value-producing costs

The first 2 are self-explanatory, so let’s focus on the third.

Non-value-producing costs are costs that are a product of delivering your product but don’t add value to the service. Common ones are:

  1. Shipping and handling
  2. Overtime in service businesses
  3. Credit card or bank processing fees
  4. Returns and refunds

While some people charge for these fees, many don’t. But these can increase drastically without the end consumer realizing it.

I don’t have a magic bullet to address these other than to be aware of what they are. Shop lower cost providers, work on the delivery of products to reduce returns/refunds, and increase prices as these cost structures change.

I’ve seen multiple businesses who were resistant to raising prices because “cost of product hasn’t gone up” but they failed to account for shipping or storing cost, both of which had increased. By missing those, they were accepting less margin without realizing it.

Revenue Mix

Many businesses have more than one product and/or service.

When looking at the revenue, I typically split it into 2 categories:

  1. Core product/service
  2. Secondary product/service

These categories can be fluid or change, but which category an item falls in can and will determine my pricing strategy.

The core product or service will be the main driver of margins, but strategically increasing margins on secondary products or services can have an outsized impact.

These are also known as value-added products or services. They can really pack a punch.

Every year Apple releases a new iPhone. And each time you buy a new phone, you end up needing (or wanting) other products:

  1. Case
  2. Headphones
  3. Charging cables

While the phone will drive most of the revenue, if half the buyers buy some sort of accessory, you can drive your overall Gross Margin up by 1.53% and Gross Profit up almost 10%.

 

Would you want a 10% higher Gross Profit???

Knowing what product/service drives your Gross Margin and how to manipulate the mix is what can separate those scraping by from those thriving.

For service businesses, I’d encourage you to start offering a premium offering. One that has a higher perceived value but also higher margins.

The right customer will see a ton of value in that premium offering, but it also impacts the way potential customers react to your primary offer pricing.

Operational Efficiencies

We hit all the obvious items above, so what are some less obvious items?

A few examples:

  1. Storage fees: it costs money to store product or inventory. Are you holding too much inventory, unnecessarily increasing storage fees?
  2. Outsourcing: could you outsource or offshore labor or processes and reduce cost without a reduction in quality? As the world has become more connected, too many businesses have ignored these options and stayed with their default.
  3. Systemization of your business: could software, standard operating procedures, or productizing delivery of a service help you reduce overhead or hours associated with each product or service? There is often a lot of meat on this bone, so don’t be afraid to dig in.
  4. Employee onboarding and training: turnover slowly increases cost and is often hidden. By systemizing you can reduce the cost of turnover slightly, but the best way to reduce the cost of onboarding and training is to retain your employees. Prioritize this.

There are almost endless ways you can improve your operational efficiency and it’ll often be specific to your business.

The key here is realizing this isn’t a one-time thing, it’s an approach. It’s constantly looking for ways to improve, testing, and implement.

By seeking out a quarter percentage here or there, you can create a long-term impact on the business.

Wrapping up

Hopefully, you’ve seen focusing on gross margin is important.

At least once or twice a year you should put aside some time to get into the weeds of what’s driving your margins and how you can improve them.

This isn’t one change and done. This is a process you’re never “done” with, as market conditions are always changing.

This is the journey of small business ownership and we love it.

If you’ve had success improving your margins, I’d love to hear from you. I’d like to start sharing some real-life case studies and can anonymize data if you’d like. Just reach out and get the conversation started.