How do you use gross margin % (GM %), (or gross profit %) to run your business? These terms are often used interchangeably but are they often defined differently. Most people define gross margin $, as revenue (or sales) less the direct cost of generating that revenue; and GM % is GM $ as a percent of revenue $ which is the definition we use.
The question is: a) What is GM % used for and why should one care about it? b) What can happen if GM % is not used appropriately?
a) So what is GM % used for? The answer is for a “for profit business” is to make a profit, which we will define as Net Profit (NP). If one does not make a profit, eventually they will go out of business. NP is equal to GM $ – Fixed Cost. So at a steady fixed cost level, the higher ones GM $ the greater their NP. In general, the higher ones GM % the higher their NP will be, so one normally tries to increase their Gross Profit rate. This can be done by increasing their prices or decreasing their direct cost. Of course if one increases their prices too much, they might also reduce demand unless they can demonstrate that the higher prices they charge is clearly worth it to the client. The concern is will clients overall agree to paying a higher price without losing volume, so that one does not generate any more Gross Margin $ then before. Likewise, if one would lower cost too much they might unfavorably impact quality and/or performance which could again lower volume. So there is delicate balance of GM % that one needs. Various markets and customers react differently so that it is important to know the dynamics of your market as regard to price sensitivity and GM %.
b) The next question is what will happen if GM % is used inappropriately? The answer lies in the trade off between GM % and volume to maximize NP. If one increases their GM % and does not significantly reduce volume all is well. But if a higher NM % is more then offset by lower volume and reduces NP that is counterproductive. The objective is to maximize NP not NM %.
Here is an example. Let’s start with a NM % of 20% and volume of $100, so NP $ is $20.
If NM % rises to 25% and volume is reduced to $90, the NP will be $22.50 so the result is better than before. If the volume is down to $75 however, the NP would be $15 which more than offsets the NM % gain. Thus if one is concerned about increasing NM % and does not focus on the more important impact on NP they can make the wrong decision.
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