Ask Doug and Polly: Taking Your Business to the Next Level | Economic news
BY DOUG AND POLLY WHITE Special Envoys
QUESTION: I’m a small business owner and I’ve been told that I have to be very careful with gross margin. What is your point of view ? Should I focus on gross margin?
ANSWER: The short answer to your question is “yes!” However, a few explanations may be useful. Gross margin is defined as revenue less cost of goods sold (COGS) or cost of services provided. These are the costs directly associated with producing the products or providing the services that generated the revenue.
Costs typically included in COGS include materials, direct labor, and overhead required to deliver the product or service. As a rule, these costs evolve in direct correlation with sales. If sales increase by 25%, COGS will also increase by about 25%.
Costs typically not included in COGS are costs associated with sales, senior management, accounting, finance, human resources, etc. These costs are sometimes referred to as selling, general and administrative (SG&A) expenses. General and administrative costs are generally more fixed in nature.
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If sales increase by 25%, general and administrative expenses could remain relatively constant in dollar terms.
However, there are exceptions to this. For example, sales commissions, which are usually included in general and administrative expenses, frequently change in direct correlation with sales.
Gross Margin Percentage (GM%) is calculated as follows: GM% = (Sales – COGS) / Sales) x 100. GM% usually remains fairly constant. A significant decrease in GM% may signal a problem. A significant increase in the percentage of GM, although positive, should also be investigated. Management needs to understand the reason for GM% changes. Calculating the GM% at the company level, while necessary, is often not sufficient.
Companies that have multiple jobs should track GM% at the job level. We worked with a home care provider who didn’t do that. After investigation, we discovered that there were several instances where caregivers were paid more per hour than their client was billed – a clear opportunity for improvement.
Companies that sell multiple products should track GM% per product. Failure to do so may result in products that have a negative gross margin, i.e. the cost to manufacture the product exceeds the selling price.
In such cases, companies might consider raising prices, reducing the cost of manufacturing the product, or discontinuing the product. There’s an old adage in the business world that you can’t offset a negative gross margin by increasing sales volume. It’s true. If GM% is negative, selling more will further reduce profits or increase losses.
Similarly, companies that offer different services will want to calculate the GM% for each service line. For example, an auto repair shop will want to know how much it makes doing oil changes, tune-ups, and valve repairs. This information will inform pricing and help the owner decide which services to advertise.
Finally, GM% should generally be tracked by area of responsibility. For example, if you have multiple salespeople, it may be instructive to calculate the GM% for each salesperson. This is especially true if the sellers have any influence on the price. In fact, many salespeople are paid based on gross profit dollars generated from their sales.
Monthly company-level GM% tracking is essential in almost every business. However, calculating GM% at the more granular levels described above can also be invaluable. The specific metrics needed will differ between companies, but the tips above will help you design the right ones for your situation.
Doug and Polly White own a significant stake in Gather, a company that designs, builds and operates collaborative workspaces. Polly focuses on human resources, people management and human systems. Doug’s areas of expertise are business strategy, operations and finance.