More gross margin, more cash flow right? Let’s look at ways of improving this key driver.

By definition, gross margin is the net revenue less cost of goods sold. It is the profit that comes in from the business’s operations. So the more the gross margin, the more will have to be the gross income to handle overheads and net profit. Gross margin must be increased without increasing costs. Gross margin plays a crucial role in manufacturing, wholesaling and retail businesses simply because it takes care of overhead costs, finance costs and income tax. To ensure that there is enough gross margin, a business must have a strong motivation and monitoring system in place so that everyone works towards maximizing the gross margin.

It is not difficult to increase sales volume. But you cannot be so sure about a proportionate increase in gross margin. Therefore, everyone on the team must focus on profit and cash flow to help the business achieve maximum gross margins. It is important to be aware that gross margin can vary from product to product and this understanding must manifest itself in the budgeting, commission and  advertising plans.

Gross Margin Has Two Aspects

In gross margin, while raising  price and cost reduction are the two aspects.  Either of these can affect gross margin. Costs can be reduced by varying order quantities and negotiating discounts. Finding a supplier who can provide warehousing can save costs. Some parts of your operations could be outsourced or sub-contracted to someone with lower operating costs. Company value can increase only through an understanding of the cash drivers, along with strong discipline and time. This must be followed up with proper communication and action.

When it comes to price, any changes the analysis must be focused on finding a balance where there is improved chance of spread between total costs and total revenues. This can be accomplished by finding the product or service most valued by customers, enhancing communication of this value message and developing incremental value both in actual and perceived terms. The increased costs and revenues must be assessed accurately. It can be tough to reverse or rectify bad pricing decisions.

Repricing depends on  the existing pricing’s appropriateness. This means you need to know how the market perceives the value of your products or services. There is the likelihood that the market will accept some price increase. When it comes to  communicating the value message, it could be more expensive particularly if the product is very similar to a competitors product ( I recommend reading the book Spin Selling by Neil Rackham, it is a great read on the topic of value selling). If the product is significantly different it might be easier to  increase its price, based on how well the customer understands the difference. Next comes value creation. This is a combination of repricing and value communication, apart from redesigning other aspects of the business like product, service, maintenance, follow up processes, etc. These could vary from business to business.

In pricing, it is important to review it keeping in mind competitive, technological and macro economic events combined with what the customer perceives. In a business where gross margin is a major cash driver, any decisions must be based on figures that are close to economic reality. If not there could be a negative cash flow effect.

Determining Gross Margins

In complex manufacturing businesses where there are multiple products, it is best to do activity based costing for cost estimation process for each activity in each department of the factory. In merchandizing businesses, it is more important to manage purchase and inventory. Thus at the heart of maintaining gross margins lies the following:

a. Timing

b. A sense of the market

c. Use of hedging

d. A knowledge of when to take markdowns

Naturally, receiving the right information when it is needed the most and in the right usable form.  Special care must be given to the reports brought out by your accounting, finance and IT departments. How these reports are used and perceived, and to whom they are accessible is important. These routine reports must be understood well. While analyzing the business from the perspective of gross margins both marketing, purchase and production departments must be kept in view. In smaller businesses, this type of reporting done usually by the owner and is a much more simple process to get a handle on.

When gross margins reduce, it could mean that the business does not have the required power to raise its prices. For those in production, purchase or product development, it makes sense to be on the lookout for what the customers perceive as value. This means, anything that might enhance product quality or makes it more useful to its customers can positively impact gross margins.

Gross margin analysis also relates to distribution channel strategy. So anything that relates to pricing, gross margin and distribution channel is closely intermeshed and must be considered together. It is important that there is a process flow that results in ultimate customer satisfaction. Also important, is the fact that this sequence of events must also aim at best performance and price.

In a direct selling situation, the demand is driven by customers who appreciate the reduced prices resulting from the absence of a number of participants and steps in the distribution channel. Things have become much easier now with the advent of the Internet where online business is quite common.

Gross Margin In The Service Business

In the service industry, there is often no tangible inventory. This means there are resources that cannot be ceased or bought when there are changes in the market place. For example, airline seats, hotel rooms, training staff on hire, etc.  In such scenarios, managing resources and support systems is a critical affair to maintain gross margin since one pays for something one does not use. Obviously, last  night’s hotel room cannot be used the next day; if the staff is idle today, this cannot be utilized tomorrow. It brings home the point that service is perishable inventory. Thus, this is an operating expense as well as a gross margin issue.