Not too long ago, I was making a presentation to a prospective client, when he asked me which single metric he should stay most focused on.

I thought at that moment that he probably expected me to recommend sales, or perhaps inventory turnover, since that was what we'd been primarily discussing up to that point. But I didn't need to think twice. The metric that I recommended he focus on, day in and day out, like a laser beam, was gross margin.

Don't get me wrong. There isn't a small retailer alive who doesn't track sales and keep a tight rein on expenses, and woe to any small retailer who takes his eye off the inventory ball. But the most critical metric, and the most overlooked on an ongoing day basis, is gross margin.

Gross margin isn't something that most small retailers think of tracking on a weekly and monthly basis. They rely on their markup formulas, and assume that gross margin will naturally flow from there. But gross margin is too important to be left unattended. It's right in the middle of everything. It flows directly from sales, it's a leading indicator of profitability and cash flow, it's the dollars that cover the expenses, and it's a critical element in measuring how productive your inventory investment is.

Here are several thoughts to keep in mind about managing gross margin:

  • Gross margin can be stated as gross profit dollars or as a percentage of sales, and it's critical to manage both. Gross profit dollars is what pays the bills, but gross margin percentage is the metric that you manage day in and day out to generate those gross profit dollars.
  • Just about every small retail software package reports out inventory value at cost, but the better ones also report it out at retail value. This information is invaluable because it allows a small retailer to calculate the weighted markup on the current inventory, which is a leading indicator of future gross margin. Once you can project future gross margin you are in a position to manage it. And if your system can report out inventory value at cost and retail by category and subcategory, your ability to manage future gross margin becomes even more refined.
  • In order to use the markup of your inventory to project your future gross margins you must understand the spread between the markup and gross margin. The markup of your inventory is frequently called initial markup, because it's where you begin. But in order to sell it, you may have to discount it, promote it or mark it down for clearance at the end of the season. Gross margin is the profit you actually earn when you sell it after any discounting or markdowns; it is frequently called maintained margin. This spread will be specific to your business, depending upon your level of promotional and clearance activity.
  • Margin erosion will naturally occur unless you actively manage your markup percentages. Several factors can cause overall margins to erode, including: competitive price pressures forcing below-standard markups; vendor price increases pushing retail prices up against natural price points; and unanticipated shifts in sales mix toward lower-priced and lower-margin merchandise. Offset that erosion by challenging yourself to be continuously improving margin percentages, even if it's only by tenths of a percentage point each quarter.
  • Even subtle shifts in the composition of your sales toward lower-margin departments or categories can have significant impact on your overall gross margin. Tracking the sales contribution by department and category by week or month can provide you the early warning you need in order to protect your gross margins. When you see this shift in sales composition occurring, you must aggressively look for opportunities to take additional markup to compensate, either in your existing inventory or in incoming purchases.
  • Avoid standardized pricing formulas, such as keystoning, which only serve to cap your upside margin potential, and assure margin erosion. Rather, build your pricing policies around the inherent value you and your merchandise offer your customers. If, for control purposes, you feel you must impose pricing formulas on your buyers, assign formulas to each department, and even each category, that are specific to the inherent value each department or category offers your customers.
  • Avoid $.99 price endings for retail price points under $10.00. At these price points, an extra nickel or dime could have a significant impact on the overall gross margin dollars generated by higher volume items. A $.99 ending locks you into an all or nothing choice of raising your retail a full dollar or standing pat, and competitive pressures will almost always force you into standing pat. Having more price points to choose from gives you more options when you think you can get an extra nickel or dime, but not a full dollar more.
  • Nothing melts margins faster than markdowns. It's like an ice cube on asphalt in July. Protect your margins by managing your inventory conservatively. Every purchase you make carries some level of markdown risk. Your objective should be to minimize that risk. Excess inventory invariably exposes you to far greater margin risk than upside sales potential.
  • Finally, there is most likely going to be a difference between the gross margin percentage reported by your computer system and the gross margin percentage reported on your financials. Your system is likely to include only the invoice cost in its margin calculations. Your accountant, on the other hand, will likely include additional items such as freight and vendor discounts in the calculation. Over the course of a quarter or a year, the relationship between the gross margin percentage reported by your system and the gross margin percentage reported on your financials should remain fairly constant. You can use this relationship to project the margins that will be reported on your financials from the margins being reported by your system.

Nobody likes surprises, especially small retailers. There's nothing pleasant about learning at the end of a quarter or year that profitability and cash flow aren't what they should be because gross margins came in below budget. The small retailers who actively manage their gross margins not only won't be surprised by their quarterly or annual results, they will quickly discover that profitability and cash flow will consistently beat their budget projections. And that's the name of the game.