Have you ever wondered where the “bottom line” starts? It actually doesn’t start on the bottom. The “bottom line” starts up higher on the income statement with a healthy gross profit margin (GM). Simply stated, GM is the value of sales less the total cost of the product or service sold. It is a critical measure in any business. An expanding GM line is the result of good decision making about the price and cost of your products or services. 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 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 margin then the customer’s value equation is likely out of balance.
So what can be done to increase gross margin? 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.
As a CFO, helping clients improve gross margin 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. I encourage anyone reading this to work with your CFO to ensure your business is at or above the industry average in GM and clear the path to reaching your targeted bottom line profit.