The Gross Margin TrapApril 4, 2021
Over the years I’ve witnessed many a company and many a manager bidding work, projects, or production and falling into what I call the “gross margin trap.”
My go-to example I share with clients is one of a newly promoted project manager who was boasting of all the profits his efforts were bringing into a company. “We’re making 40%!”
We didn’t want to, nor did we burst this manager’s bubble, but rather had to run through some actual costs to highlight what the actual project and program results were. It turned out the company was barely covering cost on his projects, as well as others.
It is common for folks that bid jobs, manage projects and produce widgets to often forget about the categories of cost in a company. (It’s a flawed assumption to assume that the senior managers are paying attention to profits.) It’s tempting to think that a product or service sold for $10 and has $6 in cost, means making $4 (40%) but in reality, that quick benchmark might only be accounting for the top half of the income statement.
Generally income statements are as follows: Income or Revenue, minus cost of sales (or cost of goods sold) = Gross Margin. STOP. Or, at least, this is where many managers do stop. What about SG&A (Sales, General and Administrative Expenses)? Overhead, taxes, e.g. Insurance. Utilities. And, who pays for the office snacks and the water cooler?
Could your salespeople and project managers possibly be underpricing your products or services with focusing on GROSS margins which only cover the top half of the income statement?
Different companies calculate their income statements different ways, some may include overhead allocations in direct and indirect costs (COS, COGS) and others may put these costs more in SG&A.
Many companies which find themselves needing restructuring or turnaround counsel have a poor handle on all of the costs going into the delivery of the product or service.
Following the lower half of the income statement, and accounting for additional overhead and other costs may very well mean that the product or service you’re selling for $10 is actually costing $12 to deliver or produce. So, you can find yourself with a net loss instead of net income when all the costs are loaded in.
MARGIN VS. MARKUP
If it costs $60 to produce your product or service (assuming that now you have all of the costs loaded into your model) and you’re selling it for $100, you are “making a 40% margin,” correct? HMM.
The cost is $60 and the sell is $100. So, the MARKUP is 67%. Why? Take the cost of $60 and multiply by 1.67. Result = $100, your selling price.
The cost is $60 and the sell is $100. So, the MARGIN of $40 represents the presumed profit on your sales price ($100-$60) margin of 40%.
So, an inexperienced manager may make the mistake of confusing MARKUP and MARGIN by taking cost ($60) and multiplying it by 1.40 which would only yield a selling price of $84, thereby shortchanging the sales price by $16.
(As another example, in certain service businesses (contracting, advertising, media, e.g.) where many costs are “marked up” by 15%, many green managers would take cost and multiply by 1.15 when in reality the proper gross-up factor is 1.1765. That factor is calculated by taking 100 and dividing it by the discounted amount of 85%, thus, 100/85 = 1.1765.)
Very elementary, but a common finding in companies which haven’t paid close attention to their pricing, and thus, their margins.