Most business leaders have been there – the dreaded situation when your gross margin is dropping without you knowing exactly why this is happening. I will go through some of the more important drivers behind your gross margin in this blog post. The aim is to provide you with some guidance and ideas for where to look for problems as well as for opportunities in you gross margin. The below ideas can be used to improve your gross margin percentage, and they can also be inspiration for analyzing a dropping gross margin in order to find the root cause behind the drops.
Gross Margin Percentage defined
Loosely defined, the gross margin is the difference between your net sales and your cost of goods sold. This gives us two major factors to work with, i.e. income and costs. In my experience, one of these are commonly forgotten. In some companies there is an absurd focus on the costs but not that much on the revenue side of things. In other organizations it seems to be the opposite: revenue is the only thing in the spot light. I will try to approach this in a more balanced way in this post. I will focus primarily on the gross margin percentage here, i.e. it will not be too much talk about volumes.
The Gross Margin Percentage is the percentage of your net sales amount that is left after the cost of goods sold has been removed. Example: 100 (Sales price) – 60 (Cost of Goods Sold) = 40 (Gross Margin). Your Gross Margin Percentage is then 40/100=40%.
Improve your gross margin percentage – 5 tips to increase revenue
Here we go, here are five ideas on how to increase the net sales number and improve the gross margin percentage from a revenue stand point. On the income side, there are several things to work with. Selling additional units at the same price will increase your gross margin in money, while the gross margin percentage will stay the same. In our list, we will focus on items that actually grow the gross margin percentage.
1. Increase your prices or lower your discounts
Sounds simple enough: Increase your prices!
If only management and leadership spent as much time on price increases as they did on cost savings. Increasing the prices is often forgotten according to my experience. Pricing in itself is also a topic wide enough for one or several books (in fact, I have read a few already), but let us stay simple again.
Always consider how to motivate a price increase and try to assess what a price increase can lead to. No need to increase the price by 10% if it means you will not sell anything – that’s hardly an improvement, right?
Consider annual price increases, at least at inflation rate levels. Watch your competition, consider your value proposition and set a price adjustment in a thought through way.
Lowering your discounts if any, will save the same purpose. Sometimes this is easier since a discount reduction is not necessarily perceived as a price increase although it pushes the net sales price upwards.
2. Product Mix: Focus on the products with the highest Gross margin
If you, like most companies do, have several different products for sale, then please consider the product mix and the data of each product. If these products are interchangeable alternatives, you might want to make sure that your sales force has enough knowledge on what makes most money for the company. In the example below, it is best for the company if you sell the cheapest product since that gives the highest gross margin both in percentage as well as in absolute money. It is not uncommon for sales people to strive for selling as much as possible, but sometimes that is not the best thing to do financially.
|Product||Sales Price||Cost||Gross Margin||Gross Margin, %|
3. Use value based pricing rather than cost pricing approach
Make sure you are pricing right, factoring in the customers willingness to pay and the value of the product or service sold. In example 1 above, it is very likely that product A could justify a higher sales price than 100. If product C sells at 80 with a cost at 30, product A should be valued higher than 100 with its’ cost at 70, otherwise something is wrong. Perhaps it is more robust and long lasting – this would be an argument for a higher price of course! Again, pricing is a huge topic which deserves its own blog post sometime in the future.
4. Options & Upgrades: Add some extra cream on top!
Sometimes it can be much easier to focus on selling extra options or features when the basic core of the deal has already started to materialize. This opens up a lot of pshycological tricks and negotiation tactics to be the topic of entire books. Let us keep it simple in this blog post. Let us say someone is buying a piece of machinery, let’s say a computer. The basic computer itself is likely the bulk of the cost and the most comparable and hence most price competitive part of your offering. Is there a chance you can package your products differently in order to increase the gross margin % on your entire sale?
|Sales Price||Cost||Gross Margin||GM, %|
|Training material/online course||20||1||19||95%|
5. Product content: Reduce content without dropping the price
Lower the content of the product but keep the price at the same level – a de facto price increase in the end. This could mean removing additional warranty, deliver an electrical product without a charger, reduce the portion size in a food item or something similar. This method is widely used but can also be seen as unethical if you try to “sneak” in this change. Some food manufacturers reduce the package sizing in such a sneaky way that no one notices. This leaves people with the notion that they are getting the same volume as before at the same price point. Consider this carefully and if you do this, do it in a good way or you might get a hit on your customer loyalty.
Improve your gross margin percentage – reduce costs
This is a bit more straight forward in my opinion. Perhaps that’s why it seem to get more attention from managers and leaders out there. Reduce the costs without resulting in a reason to reduce the sales price. (I.e. do not impact life time, quality or performance of the product in such a way that it has less perceived value. If that happens, it could prompt a price reduction and the gross margin percentage improvement would be gone).
Cost reductions are tangible, consequences are easier to assess. Essentially, you know what you get compared to sales price increases which is a very difficult guessing game. Our four ideas on how to improve the gross margin percentage by reducing costs are as follows..
1. Reduce raw material and components costs
Sourcing is a vast field of expertise, so I am not planning on covering it all here since this is more of an idea stimulation article than anything else. So, what should you do?
- Negotiate with your suppliers to lower the prices. Demand price reductions.
- Perhaps you can buy higher quantities at the same time? This could mean a lower cost per unit.
- Have alternate suppliers to increase competition and play them out against each other. (Remember, suppliers also have to live and have a sustainable business. Pushing them too far means they will suffer or stop selling to you.)
2. Reduce consumption of material and components
Can you cut your material to reduce waste? Can you use 4 bolts instead of eight to keep that top lid in place? All this will lead to reduced costs and an improved gross margin percentage.
3. Save on labor cost to improve the GM percentage
Is it possible to adapt your manufacturing process so that you can get more out of every work hour? Batching? More systematic approach? Could you use your high cost and high skilled labor specifically for those tasks they are absolutely required for? Perhaps by hiring a few more low skilled people you can free up the high skilled ones and remove a bottle neck. Adding resources to lower the costs seems counter productive but it can still mean your cost per unit can go down, as long as you can sell more of course. If you can’t sell more, then perhaps you need to re-balance anyway, but downwards. Refer to the example in the table below. If you reduce the cost per unit and retain the same or a higher sales price, your gross margin percentage will improve.
|High skilled workers, 20/hour||Low skilled workers, 10/hour||Output||Cost per unit|
|Start case||4||4||8 units/hour||15/unit|
|Add low skill labor||4||6||12 units/hour||11,7/unit|
|Reduce high skill and increase low skill labor||3||5||8 units/hour||13,75/unit|
4. Improve Gross Margin percentage by lowering freight costs
Can you order components once a week instead of small deliveries every day? This could save you on shipping costs. Can you pack your outgoing deliveries in a better way? Perhaps by improving packaging routines and material you can fit another unit on that half pallet you send out – this can result in lower shipping costs which in turn would improve your gross margin percentage.
Conclusions on improving your gross margin percentage
As you can see, there are many ways of increasing your revenue or reducing your costs – both areas contribute to an improvement in gross margin percentage. These are not the only ones of course, it’s merely a spontaneous selection on my part.
Please, do not underestimate the difficulty in increasing your sales price in a smart and low risk way. Depending on your industry, this ranges from easy to extremely difficult. I do recommend some further reading and training on pricing on the way.
Do you have any additional suggestions to this short list of GM improvement ideas? Please comment? Do you have good or bad experience from deploying any of the above? Tell us more in the comment section. Looking forward to hearing from you!