The Importance of Gross Margin
One vital aspect that I often see entrepreneurs overlook in starting and managing a business is that of gross margin. Gross margin (sales minus direct costs) is what is left over after costs associated directly with the sale of a product or service, such as materials and direct labor, are paid for. This is an extremely important number for every new and small business to manage, as it impacts both the likelihood of reaching breakeven and the amount of profit that is earned beyond breakeven. In other words, it directly impacts risk and return.
As a simple example of how gross margin affects breakeven and profit, consider a start-up with $300,000 in fixed overhead. If this firm's gross margin as a percent of sales is 50% (which means fifty cents out of each dollar in sales is retained in the company to cover fixed costs), it would need to reach sales of $600,000 to cover its overhead. If that same start-up were able to achieve a gross margin of 52% instead, breakeven would decrease by $23,000, or approximately 4%. The company would then begin earning a before-tax profit of fifty-two cents on each dollar in sales after revenues reach $577,000, rather than fifty cents on the dollar after $600,000.
Managing gross margin helps a firm avoid problems with prices that are too low and direct costs that are too high, and hence problems with breakeven and profit. When a firm is generating adequate sales but gross margins are low, it signals an issue in one or both of these areas. One example of this is a newly-formed bakery that was losing money each month, even though it was quickly gaining a reputation for having the best tasting, most intricately decorated cakes in the area. This was a real problem, since the bakery had already reached its production capacity and was turning away customers, but it still was not generating enough income to cover fixed expenses. A quick analysis revealed that gross margins were inadequate and that pricing was to blame: Though the bakery had higher quality cakes with more expensive ingredients, prices had been set at the level of the competition in fear of losing customers to lower prices. Considering that customers clearly perceived this bakery's cakes as better than the competition, that there was a waiting list of customers, and that most sales were for events such as weddings where customers are relatively price insensitive, it became obvious that prices needed to be raised.
Another example is an independent flower shop that had recently opened and was having issues with cost controls. Like the owner of the bakery, this owner was looking for assistance because she was not generating nearly enough income to cover her costs for rent and employees. Some investigation into gross margin revealed the problem: Though her prices and sales figures were in line with her competition, her employees were not being attentive to the cost of materials being put into bouquets. Because of this, the cost of labor and materials for a typical bouquet was actually higher than the price being charged; in other words, she was losing money every time she made a sale. By instituting some cost controls, the owner was able to begin earning a profit on her flower arrangements.
In both cases above, the owner did not know what gross margin on sales was for the business and therefore could not identify and address the problems they were experiencing. Each owner simply knew that the business was losing money and did not know where to begin to remedy the situation. This lack of understanding often leads to decisions that only worsen the company's position, such as attempting to increase sales via lower prices, leading to even smaller gross margins.
The moral of the gross margin story is that it often does not get the attention it deserves. Starting out, you should be aware of the factors that will impact your margins and pay close attention to them. Find a benchmark for gross margin using data on your nearest competitors or using industry averages (a good place to start is the Robert Morris and Associates Annual Statement Review) to give yourself a target to manage toward. Also, be aware that the factors impacting gross margins may change over time. For instance, as your business develops you may begin generating enough cash to be able to take advantage of volume purchasing discounts or discounts for upfront payments. You may also find that your costs increase due to inflationary factors and that you need to compensate for this with annual price increases. Finally, track your gross margin over time to be sure that it does not slowly deteriorate and lead to cash flow problems.
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