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It’s been a while since we focused a column on gross margin (GM) so we want to introduce it to the latest group of new people in the industry and remind the seasoned veterans of the importance of a proper understanding of GM.
Gross margin is probably the most important concept in profitable wholesaling — yet one of the least understood concepts in the industry. This lack of understanding is at the heart of many profitability problems in hard-goods wholesaling.
How do we know?
We have tested more than 10,000 wholesaler employees over our careers and have seen it first-hand. Just last week, in Rich's marketing seminar at the recent HARDI Sales and Marketing FOCUS conference in Charleston, S.C., we tested an additional 72 people who attended. (As an aside, it was a great meeting with sessions focused on getting attendees to think inside, outside and all around the proverbial box. HARDI has additional sessions coming up on purchasing and another on operations & logistics, so check their website for more info.)
The group was not a completely representative test since some of the attendees had seen the test in previous meetings. (We’ve been using the same test for 30 years and find that some people cannot get all the answers even though it is their second or third attempt.) Plus the attendees were mostly experienced managers and senior managers.
Even with this positive bias, only 10 of the 72 attendees answered all five questions correctly. That's just shy of 14%. Here's the crazy part — 14% is one of the best, and might be the best, showing of any group we’ve encountered.
We have tested similarly constituted groups where not one of the attendees answered all five questions correctly…including the CFO. Many of the people used their calculators, tablets and laptops to compute their incorrect answer with five digits of accuracy...or maybe it was five digits of inaccuracy.
Your people don’t understand GM
It is pretty safe to assume that your company is a typical wholesaling company and that most of the team does not understand gross margin. Even if you conduct periodic training and allow them access to the company’s financials, when push comes to GM computation, they will not be able to use it properly.
Why does it matter?
The most important reason is that GM is often confused with markup. So the first important lesson is that gross margin and markup ARE NOT THE SAME. They are calculated differently and are only equal when they are both zero.
They are a little like liters and gallons. Both represent a measure for liquids but the amount of fuel in your tank is different when you have 25 liters versus 25 gallons. In a similar way, the profit in a sale is different when the gross margin is 25% versus a markup of 25%.
While the proportion is different, think of markup as liters and gross margin as gallons. When the percentages are equal, markup is smaller representing less profit and less money. (As an example, a 25% markup is equal to a 20% GM.)
Another reason to not use markup is your team’s perception of the size. A 100% markup generates the same price in dollars as a 50% GM. Some people cannot emotionally stomach 100% but can handle 50%.
Your computer does all the computing
First, over the years we have encountered computer systems written by programmers who didn’t understand the difference. So make sure that you double check the math. Assuming that the computation is correct, most computer system allow both GM and markup. When your team thinks that GM and Markup are equivalent they might be entering markup when you ask for GM. In some systems, markup is easier to enter so markup is used instead of GM.
Only use gross margin
In your business, insist that your team use only gross margin. Continuing the fuel analogy, if you are running an airline where proper fuel calculation is a life and death issue, you don't want confusion between the guy filling the tank and the guy creating the flight plan.
When the flight plan requires 25 gallons of fuel to reach the destination and the refueler only puts 25 liters in the tank, there will be a landing somewhere short of the destination indicated on the flight plan.
This occurs every day in our industry resulting in profit production that is short of the destination on the flight plan/budget.
What is gross margin?
Gross margin (also called gross profit) is an accounting term that describes the amount of money remaining after a sale has been made and the product supplier has been paid for the product and any inbound freight has been paid in order to get that product on the shelf in the warehouse ready to sell.
The gross margin is often described in raw dollars and as a percentage of sales. So if you sell an item for $120, you pay the manufacturer $70 for the item and item is shipped to your warehouse with free freight, your gross margin in dollars is $50. The calculation is $120-$70=$50. On this same sale, the Gross Margin percentage is 41.66%. The calculation is $50 / $120. Since we divide the gross margin dollars by the amount of the sale, the resulting GM percentage is said to be “as a percent of sales.”
“As a percent of sales”
Several important metrics within the company are measured both in raw dollars and as percentages. Other measures:
1. Cost of goods sold (also called COGS)
In most cases, this is the amount paid to the supplier for the product that was sold. In the above example the $70 is the COGS and when expressed as a percent of sales, it is $70 / $120 or 58.33%.
A benefit from using measures as a percent of sales is that the percentage can help you compare numbers for different periods of time in proportion. While there are some issues, you could compare last year's delivery expense against this year's delivery expense.
Last year they were $100,000 and this year they were $120,000. On the surface this year’s charges seem much higher but when you look at them as a percentage of sales last year they were 3%, and this year the $120,000 is 2% of sales.
Thus the delivery expense didn't increase as fast as the sales did. Normally, this is a favorable trend. Conversely when an expense like compensation is going up faster than sales this is not a favorable trend.
These are all the other costs of running a business other than the COGS. They include salaries, wages, rent, utilities, interest paid to the bank, outbound shipping, commissions, etc.
3. Breakeven point (also called the nut, though we do not know why)
From a company perspective, this is the point where the gross margin from the sales is equal to the expenses. When talking about a company’s fiscal year performance, when the gross margin exceeds the breakeven point, the company made money. Below the break-even point the company lost money. So the breakeven point is generally equal to the expenses.
The breakeven point can also be in dollars or expressed as a percentage. Where it is simple to calculate the GM and COGS on an individual sale, the BE is complicated since you would have to figure the portion of each expense to apply to the sale. So a little bit of the rent, salaries, utilities, etc. would need to be applied to the sale.
This is difficult so most companies take their yearly expenses and divide by their yearly sales to get their total expenses as a percent of total sales.
Even better, the company has established a budget for expenses along with a sales budget that can be used to establish BE. This percentage then becomes a sort of average expense for a sale and allows a simple determination of BE. When the company BE is 20%, sales above 20% GM make money for the company and sales below 20% GM lose money for the company.
Of course all sales are not created equally; but for the company to break even over a year, every sale below the break even percentage must be offset by a similarly-sized sale above the break even percentage.
There is no magic. The danger in percentages is that you cannot spend percentages, only dollars. Rich has often suggested that sales people have a gross margin dollars quota that is a commitment to deliver to the company a specified bucket of dollars. (Jen would never suggest such a thing as she is still involved in sales for our company). Any concessions they allow must be offset with increases in other areas so their margin production in dollars equals their promised number.
4. Net profits
This is the profit or loss remaining after expenses are subtracted from the gross margin. Net profits are expressed in dollars and as a percent of sales. These are the dollars the company can use to pay the owners dividends for their investment or can reinvest in the company's growth. Our industry is noted for owners reinvesting their profits back into the business as opposed to taking the money out for their personal consumption.
A fair price is fair to the buyer and the seller
As we consult, we find that most humans seem to have a top-of-mind "fair" profit number, to charge the customer. This is their own personal number that they use when they set the price for a sale. Most people pull their personal number from some bodily orifice without the benefit of any real business experience or data.
They often fail to consider what is fair to their company thinking that their company is rolling in money. Often when they see a price in the computer that exceeds their personal number they feel obligated to correct the situation.
Many will simply adjust the price to their number without regard for any of the background research, competitive analysis and strategy that may have been used in creating the computer price.
Some will proactively “correct” the price to avoid a potential price objection by the customer. Some of the better people will only adjust the number when a customer complains but since customers often complain, there are many opportunities to adjust the price.
Discounts are margin points
We have said before that most sales people give away a 10% or 15% discount quite casually as if it was of little consequence. They fail to understand that the discounts given equate to gross margin points lost.
When companies are struggling to eke out another point of margin and their sales people dump margin in 10s and 15s, there is a huge disconnect within the company.
We are greatly suspicious of all whole number discounts or gross margin overrides offered under the guise of meeting a competitor’s price. A competitor’s price will always be a dollar and cents amount as opposed to a percentage.
So when we see a point of sale override to 15% we assume that sales person used his personal number as opposed to using the dollar amount stated by the customer to reverse-engineer to a gross margin percentage of 15%. If you have a “rocket-surgeon” sales person who claims to have done that, we would recommend that you ask him to show his work.
Wholesalers work hard to make each sale. It is sad to have worked so hard and then to receive profits that are unfair to them.