| December 7, 2020
The real income of a business is not Sales but Gross Margin - are you managing this key aspect of the business effectively?
Gross Margin
In most businesses costs divide into:
- Fixed (or ‘period’) costs - those that exist all of the time regardless of thoughput, examples being rent, office salaries, insurance;
- Variable (sometimes termed direct) costs - which only exist if thoughput happens, examples are materials, freight, packaging and perhaps direct labour (but see below).
It follows that by deducting total Variable Cost from Sales Value you get to a measure of the REAL earnings of the business… which can be described as the Gross Margin generated from the Sale. For example…
| Value | |
|---|---|
| Sales | £100,000 |
| Direct Costs | (70,000) |
| 30,000 | |
| Gross Margin percentage | 30% |
In the scenario above if sales increase by £1000 at 30% Gross Margin the company will only ultimately earn £300 extra towards Fixed Costs and profit.
As well as expressing Gross Margin as a monetary value it can also be expressed in percentage terms, which provides for useful comparisons between markets or ‘Value Streams’ within the business, and over time periods where volumes are changing.
So What is Your Margin Management Strategy?
The classic “market trader” strategy?
Buy for a £1, double it and sell for £2….
But what if you could buy for 95 pence sell for £2.05? Well the Gross Margin goes up to 54% which is an 8% increase (i.e. 4/50)! But how much would volume drop as a result of the price increase? This is where the concept of “price elasticity” comes into play.
Economists define Price Elasticity as:
a measure used to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price, ceteris paribus.
There are short and long term effects, obviously, but the following may illuminate why cutting prices for volume may NOT be the right thing to do….
Effect on Gross Margin of a 10% price cut to gain a 10% increase in volume
| Before cut | After cut | |
|---|---|---|
| per unit pricing | ||
| Sales Price | 100 | 90 |
| Variable Cost | 80 | 80 |
| 20 | 10 | |
| Units Sold | 900 | 990 |
| Gross Margin | £18,000 | £9,900 |
Think about this for a moment….. a 10% drop in price at 30% Gross Margin causes income to drop by one third!
At lower margins the effect is worse - if the starting Gross Margin percentage is only 20% dropping the price by 10% means the businesses income is halved - which is a massive cut.
What this means is extraordinary - a 10% price cut at 30% Gross Margin means sales and production would have to deliver ONE THIRD more volume to compensate for the income drop. At 20% Gross Margin a 10% price cut means delivering 50% more product. Will sales be able to deliver this volume of orders? And more to the point…. can you supply it within the current Fixed Cost base?
Effect on Gross Margin of a 10% price increase where volume falls by 10%
Conversely, if prices are raised by 10% and volume falls by 10% Gross Margin improves by one third at 30% (30% to 40%) and by half if the starting Gross Margin is 20% (from 20% to 30%).
| Before cut | After cut | |
|---|---|---|
| per unit pricing | ||
| Sales Price | 100 | 110 |
| Variable Cost | 80 | 80 |
| 20 | 30 | |
| Units Sold | 900 | 810 |
| Gross Margin | £18,000 | £24,300 |
From an income prespective, if starting at a GM of 30% a 10% price increase in prices improves income if not more than one third of the volume is lost - at a 20% starting GM more income is earned overall from this level of uplift if volume falls by less than half - and all at the same overhead (fixed cost) level.
A note about Variable Costs
It should be noted that the above divsion between Variable and Fixed costs is really a Short term categorisation since, in the Long term, all costs are variable - for example you can increase warehouse space, reduce the number of staff etc. In addition, certain costs are ‘semi-variable’ or ‘stepped’ in that they are fixed within a particular volume range but once a certain volume is reached more capacity is required until the next ‘break point’.
It is also important to understand that Variable Costs cover ALL costs which vary with volume, and not just factory costs - thus things like transport, discounts, promotional costs, variable selling expenses (samples, display stock etc) all contribute to total variable cost - a fact that is often overlooked.
In addition there is the thorny problem of Direct Labour - traditionally this has been seen as fully variable but, in the very short term at least, should be treated as a fixed or semi-fixed cost. The earlier Positive Churn post on this may help explain more on this issue.
Summary
The above shows that if you understand your cost structure, and the interplay between costs and volume, pricing decisions can be taken that will radically improve the profitability of the business. It is therefore unfortunate that in most businesses the responsibilty for margin management is not as clearly defined as overhead cost control, and that analysis of margins and prices is, at best, ad hoc and at worst non-existent.
And finally…. if you want to know more about how we can help you improve your business through better systems and improved information then do please get in touch via the Contacts Page.