Do You Really Understand Gross Margin?

If you are an entrepreneur, an investor, or a manager, you will know that gross margins are important - but do you really understand why?

Gross margin is by far one of the most important metrics used to determine a company’s nature and financial health.

What is gross margin? And what are the implications of a higher or lower gross margin? Below are some answers to these questions, and it can enhance your decision making around investing and operating businesses.

A quick recap on the accounting fundamentals: Gross margin is the gross profit of a business as a proportion of revenue, expressed as a percentage.

Gross profit is the revenue minus the cost of sales. The cost of sales are the direct costs associated with producing / delivering the product or service.

These direct costs may include direct materials, direct labor, depreciation of machinery used to manufacture the item, and shipping.

So for a company that manufactures pens, the cost of sales would be as follows:1) Direct materials: the plastic, steel, ink, etc. that are part of the pen2) Direct labor: the people on the assembly line configuring the direct materials into the pen3) Direct overhead: the depreciation on the machinery of the assembly line4) Shipping costs: the cost of transporting the pens to the end customer

The gross margin of a business (and the average gross margin for an industry) can tell you a lot about a business (or industry). In order to make an effective assessment about a business using gross margins, it should be compared against asset turnover (how much revenue a given level of assets can generate) to determine the superiority of the business.

If your company is part of an elite but small group of companies that can achieve high turnover and high margins, you are from the lucky few. Otherwise, a low turnover rate should be compensated with a relatively high gross margin, and vice versa.

The top row of the Gross Margin and Turnover Matrix will contain few companies in relation to the universe of all companies. This is because:

1. It doesn’t generally pay to be the second lowest cost player in a given market. Costco and Amazon spent billions in developing the infrastructure to enable them to provide their goods and services at rock bottom prices. These companies are exceptions to the rule.

2. Only one or a few of dominant, lowest-cost producer firms, will survive within their industry due to economies of scale and feedback loops that strengthen their inherent advantages.Long-term investors would be remiss to not include any of these in their portfolio.

There are, however, more opportunities to be a differentiator. This is because you can slice and dice the market into a multitude of niches. They may be small markets, but they can be extremely profitable since you are serving a very narrow set of customers very specifically.

So what should businesses do if they find themselves in the lower left quadrant of the Gross Margin and Turnover Matrix?

They should find ways to increase their gross margin, because it is more impactful than they realize.

A word of caution about increasing prices or cutting costs to an extreme level: there is a right way to increase your gross margin, and a wrong way.

The right way revolves around increasing and communicating the value provided to the customer. This can help move the business from the lower left quadrant of the Gross Margin and Turnover Matrix to the right quadrant. The mechanics of how to do this is outside the scope of this post.

Why bother increasing gross margins, even the increase is seemingly minor?

The incremental percentage point change in gross margin affects profitability disproportionately. Let me demonstrate for more clarity using an example of a business that sells a physical product which has a 2x markup from its inventory cost.

The company’s cost of sales, or direct costs, is called inventory here for the sake of this demonstration, but from an accounting perspective inventory that is sold is called cost of sales. (The gross margin, cost of sales margin, and the markup are all related*).

The selling price per unit starts off as a 2x markup from the cost of the unit, so the sales figure will be double inventory.Now, the company decides to increase this markup by 50%, which results in an increase of sales by 50%. This means that for the same investment in inventory, the company can increase its gross profit from 100 to 200 – a 100% increase!

One should look at how much sales can be achieved for a given level of investment in inventory for a clearer understanding of the effect that gross margin has on profitability.

The change in gross margin of 17% percentage points (from 50% to 67%) may seem meager at first, but the resulting impact is a doubling of gross profit, and an increase in EBIT by 167%.

But what if gross margins decrease? The impact also magnifies profitability, this time negatively.

Now you may say that this hypothetical example is not realistic because it does not take into account other variables such as the reduction in customers due to higher prices. You may also argue that an increase in operating expenses is warranted to build a business that sells its products at a 'premium'. So let us take that into account.

If a business really strives to increase the level of value delivered over above the price increase, they will likely do well. This is much easier for service-based businesses than for companies selling physical products, but its possible for most businesses, nonetheless.

It is true that a certain number of customers will leave after a price hike, but that's ok. Those customers would likely be the 'trouble customers' who value lower prices over value delivered. Businesses know who these customers are and I'm sure they won't be missed. But this also doesn't matter because a well-executed price increase will result in more revenue from continuing customers compared to pre-price hike times.

In the example below, I show a hypothetical business that loses 40% of its customers because of a 75% price increase.

Again, gross margins increase by a ‘meager’ 17 percentage points. The cost of sales decreases by 31% because there are 400 less customers to serve. The result is that gross profit increases by 41%!

EBIT increases by 55% in this example, even if we assume that the net increase in expenses associated with additional value creation (such as marketing and branding) is 20%.

Entrepreneurs, investors, and managers should consider all the ways they can go about increasing gross margins. This can generally be done by increasing prices or decreasing costs but there is a limit to how must cost you can cut versus how much value you can deliver. Some companies that have a high level of fixed direct costs can even increase gross margins by increasing the volume of clients they service within a given time period - these businesses are more often than not software or service-based businesses.

* The cost of sales margin is the total cost of sales as a proportion of revenue, expressed as a percentage. The gross margin is one minus the cost of sales margin.