4 ways to improve your Gross MarginsSep 14, 2023
I understand... financial statements aren't really sexy.
But what if you could cut Cost of Goods Sold by 5% and get a 10% increase in profit?
Well, today we break down Gross Margins and I gotta say... it's pretty sexy.
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4 WAYS TO IMPROVE YOUR GROSS MARGINS
Have you ever walked into a situation confident only to realize you had no idea what you were doing?
O no… only me?! Shoot…
Of course you have! We all have. Today is one of those stories.
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, as I started looking for jobs, I focused small to medium businesses.
I was never an accounting purist and at that point in my career those were my job opportunities at big companies.
But at a small business, I’d get to wear multiple hats.
So, when the opportunity presented itself, I jumped. I was over accounting but also slotted to help with 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.
Then, weeks in, I’m looking at the financial statements with the CEO. We’re talking about the last few months trends and I mention our gross margins are getting worse.
The CEO turns to me and asks “how do we fix it?”
I paused. Then I froze. I started to talk… stammering… “well… we increase price or decrease labor” I eventually spit out.
If I don’t say so myself… brilliance was just displayed. Brilliance I say.
In reality, that was it. That was all I had. So, I had to put my head down and dig deep.
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.
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:
- Revenue Mix
- Operational Efficiencies
Obvious, right? But what’s not so obvious is this: most businesses
Big businesses raise prices all the time. But many small businesses struggle because of fear they’ll lose customers.
Prices should be raised in 2 scenarios:
- Annual increases
- 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.
- Annually increase prices on everyone
- Annually increase prices for new customers
- 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 can’t provide direct advice, but if your answer is “I can’t increase prices,” I’d ask you to do the 5 whys exercise.
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.
- Look for new suppliers
- Take advantage of volume discounts
- 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:
- Shipping and handling
- Overtime in service businesses
- Credit card or bank processing fees
- 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.
Businesses typically have more than one product and/or service.
When looking at the revenue, I typically split it into 2 categories:
- Core product/service
- 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.
Since Apple just released the new iPhone 15, let’s talk about their products.
With the iPhone 15, you end up needing (or wanting) other products:
- 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.
We hit all the obvious items above, so what are some less obvious items?
A few examples:
- Storage fees: it costs money to store product or inventory. Are you holding too much inventory, unnecessarily increasing storage fees?
- 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.
- 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.
- 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.
Hopefully you’ve seen focusing on Gross Margins 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 is a process you’re never “done” with, as market conditions are always changing.
One thing to note: this isn’t one change and done. Look at all the levers and see how you can combine them.
Could I increase prices and be okay with less volume? It could be you bring more home overall.
Worth a consideration.
Reach out and let me know what questions you have and I’d love to address them in the future.