Few financial measures are more important than gross margin.

Few financial measures are more important than gross margin.

by Jan 12, 2024Advisory Groups

In my book “Great CEOs Are Lazy,” I delved into the components of an exceptional business model. Among the pivotal factors, one of the most crucial is the margin, particularly the gross margin. The emphasis here is on having substantial gross margin, ideally in abundance.

It turns out that margin is a topic that confuses a lot of business leaders, which can cause real problems when competing in a volatile environment and you might need to raise or even lower your price. Put another way, if you don’t understand your margins or how you control them, you can get into big trouble with your prices. Hopefully, your CFO can help keep this all clear.

So, let’s dig into margins, specifically gross margin, and why it’s a subtle number inside your business that can be a magic number or sink you.

Gross Margin in a Nutshell

At its simplest level, your margin percentage is calculated by subtracting your cost from your price and then dividing it by price: gross margin = (price – cost)/price.

Some businesses run with thin margins of something like 10 percent, while others, such as software companies, can boast gross margins of upwards of 80 to 90 percent.

The costs used in a gross margin calculation are all directly attributed to delivering the goods or services. None of the administrative overheads, such as human resources, finance, information technology, or executives, are included.

If we use an example of a manufacturing business, the costs we use to calculate our gross margin are everything that’s used to build our products: that’s material costs, labor costs, benefits for those laborers, and all the overhead related to the operation, such as manufacturing building costs, supplies, and even the cafeteria you might operate for your employees. You want to account for everything and anything directly related to the manufacturing of your products.

The Downside of Dynamic Margin

Some companies diverge from gross margin and use dynamic margin instead. This is calculated using the same formula, price – cost/price, but you add in only the variable costs of making your product–those elements that change when you make the product. This might mean you account for only material costs and incremental labor needed to make that last unit. As you can imagine, when you don’t account for overhead, the dynamic margin can appear quite large on that incremental unit or project when you don’t have to hire more people or expand the facility.

I have seen companies who use this calculation when aggressively setting their pricing. If you’ve already covered your fixed costs elsewhere, setting a price based on a dynamic margin allows you to drop more money to the gross profit bottom line.

But there is a real downside to calculating margin this way, because it doesn’t account for any of the overhead inside the business, which is a real cost. It might not include the cost of paying a salesperson’s commission–which can also negatively impact the business’s bottom line. Additionally, when the business isn’t growing or is shrinking, the new business won’t cover the actual overhead of the business. Further, when overhead expansion is needed to accommodate additional work, such as additional management, there may not be enough margin in the pricing to cover it.

Accounting for Overhead

The error many business owners fall into when they use dynamic margins to run their business is that they overlook the actual sales, general, and administrative costs–including their pay. In most companies, these costs, including accounting and marketing, can total 10 to 20 percent of the company’s overhead.

And that number only goes higher when accounting for any commission for your sales team. That means if you set your pricing without accounting for these costs, you might realize you’re not making any profit.

I recently saw this happen at a company setting its prices based on a dynamic margin. They were dealing by a thin margin of 6 percent, but they thought that was OK. However, they neglected to include the salesperson’s commission in their dynamic margin calculation. Suddenly, they realized their salesperson was the only person winning when they sold anything because the work was priced at break-even or below.

Knowing Your True Costs

Understanding the true gross margin of your business is as basic as it gets. But it’s a lesson some business leaders miss. Your goal should be to truly understand the total costs of your business to ensure you can generate ample profits for you and your shareholders. It is OK to consider dynamic margin, but you need to be careful it is truly incremental work with limited additional costs.

That means whether you use gross or dynamic margin, don’t overlook your direct and indirect overhead and SG&A costs when setting your prices. If you don’t, you’ll find yourself doing a lot of work and not making any money.