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• 4️⃣ Driving gross margin; as easy as 1,2,3,…..4?

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THE DEEP DIVE

How to improve gross margin in your business

Over the first 4 issues of CFO Secrets, we explored the CFO role in detail.

Now we are going to change angle…time to get into the numbers.

Specifically … the Income Statement (IS or P&L for short).

Over the next 6-10 weeks, we are going to dive deep into the IS and laser in on how to drive and move the numbers in your favor.

Good CFOs don’t read the news. They make the news. And the big money CFO roles are reserved for those that know how to create a volcano of shareholder value.

Many of the world’s best long term investors (Buffett, Munger, etc) look first for gross margin. They use it as the #1 indicator of the quality of the underlying business.

They are looking for a business with better sustainable gross margins than competitors.

We are going to break gross margin down. But more, we are going to explain what you can do to improve the gross margin in your business.

What is gross margin?

A quick recap on the basics.

Gross margin is the difference between revenue and cost of sales (COS), divided by revenue. Expressed as a percentage

Revenue is straight forward to understand. No definition necessary.

COS is the direct costs associated with making a product (or delivering a service). Exactly which costs are ‘direct’ or not is subjective. So much so, that we’ll dedicate an entire newsletter to this point in a few weeks time.

The best way to get under the skin of Gross Margin is with an example.

So let’s imagine you have a coffee shop.

You sell one product; a $5 Americano. 2,000 units per week.

You employ 2 people working 40 hour weeks at $20 per hour.

Let’s break down the margin. We’ll ignore sales tax to keep things simple) and assume labor is directly attributable to sales.

Here is the calculation of the gross margin of the business:

So the gross margin is 62% or $3.10 per cup.

The more important question is what needs to happen to improve that margin

With gross margin, small changes make a big difference.

If you can improve that 67% by 300 basis point to 70%, that drops all the way to the bottom line.

So if your net margin was 7% before, assuming the rest of the cost base doesn’t change. Then your net margin would also improve by 300 basis points; i.e. to 10%.

Moving net margin from 7% to 10% is a 43% improvement in profitability. This is high stakes stuff.

There are 4 levers to impact the gross margin of any business:

1. Selling Prices

2. Input Cost Prices

3. Sales Mix

4. Gross Margin Conversion

1. Selling Prices

The most direct lever on gross margin, is sales prices.

Let’s see what happens to margin for two different scenarios; a $1 price increase, and a $1 price reduction:

On a $1 price increase your margin expands from 62% to 68.3%, or to $4.10 per cup

On a $1 price reduction your margin contracts from 62% to 52.5%, or to $2.10 per cup.

In practice, a price increase likely means selling fewer cups of coffee. This affects the P&L further down (below gross margin). This point is so important, we’ll pick that up in a future newsletter dedicated to this point.

But, a valuable brand, gives you the ability to price above your competitors. Customers are buying into something bigger than the coffee itself.

This is why many of the most valuable companies in the world, tend to be large brands. The Starbucks brand gives real gross margin headroom vs competitors.

They can either take this headroom as profit, or they can invest it in lower prices to drive sales volume. Either way, it’s a moat that creates shareholder value.

2. Input Cost Prices

The second lever on gross margins is changes in input prices.

If your input prices go up, that will reduce your margins. Unless you mitigate it with one of the other three margin levers.

And reduce the cost of your inputs and your margin improves.

But how do you do that?

There are two ways:

a) Negotiate better pricing. This tends to come with scale. You will get a better cost price per lb of coffee beans, the more beans you buy. This is a cost advantage of being a scale operator. I.e. An independent won’t be able to buy beans cheaper than Starbucks. They will be able to cut out 2 or 3 middleman, optimize inbound transport and storage.

b) Different specification. In this case, that means buy cheaper beans. This risks product quality which risks brand (and so future volumes). Or pay less for the staff, which risks service quality (and so future volumes)

So what does a input price reduction look like in gross margin.

As an example, let’s imagine you have reduced the price at which we buy beans from $20 per lb to $15 per lb:

Referring back to our original base margin of 62%. A $5 per lb reduction in the price of beans will improve your margin by 250 basis points to 64.5%.

Buying well is foundational to strong gross margins in product based businesses.

3. Sales Mix

Let’s imagine we introduce a second product. A scone.

Price is $5, and the cost per unit is $1. This product has an 80% margin.

That means for every scone you sell, you improve the margin mix. The 80% has an enhancing effect on the total margin.

I.e. in our base case 100% of products get sold at 62% margin. By introducing the scone that number will be less than 100% and a % of products will now get sold at 80%. This drags the total weighted average margin up.

Imagine you sell 500 scones per week (20% of total sales) at the higher margin.

Let’s see it on the Income Statement:

Gross Margin has increased to 65.6% from the 62% base position. And profit per cup has improved to $4.10 (assuming the scone is an upsell from a cup of coffee).

In practice, mix effects are complicated.

Most businesses (including coffee shops) have many products, all with different margin. Then there are new products, products delisting.

And mix effects are difficult to isolate. There is a cause and effect relationship with both sales pricing and volumes sold.

So managing mix well is a tough job.

Good management teams will actively manage mix. Through pricing, delisting weak margin products, introducing stronger products, etc.

Bad management teams will hide behind ‘mix’ as a balancing number.

Here’s a simple rubric. If a management team blame underperformance on mix, without being specific, it means they don’t know what’s going on in their margin.

4. Gross Margin Conversion

This is my favorite of the four drivers.

It often gets missed, so by default, this is where the hidden gold is.

Gross margin conversion is about how to make more output with less inputs.

Let’s assume you notice that you are wasting 10lb of coffee beans a week. And through better planning, and clearer standard operating procedures (SOPs) we remove that waste.

Also assume that you allow customers to use their own cup (rather than disposable cups at $0.20 be unit) and 20% do so.

Finally, by upskilling your Barista, they could run the shop alone. This reduces the labor needed from 80 hours to 40 hours, but in turn you must pay more. $25 per hour rather than $20 per hour.

Income Statement:

We have increased margin from 62% to 71%. This shows the power of gross margin conversion. We have improved margin by 900 basis points. All without touching sales prices, input prices, or sales mix.

Gross margin conversion is about improving the efficiency ratio of inputs required to create a unit of output.

If this feels like ‘free money’, often it is. But it’s hard to unlock sometimes. Reducing waste is more easily talked about than delivered. There also can be a risk of compromising product quality through over efficiency which can be brand damaging.

Gross margin conversion factors are industry specific. Often unlocked through better, more efficient operations.

KPIs are critical here. In this business the margin efficiency KPIs (as an example) could be Cups sold per labor hour, and Coffee Waste %.

Again, using KPIs to measure gross margin efficiency is so important, we’ll dedicate a newsletter to it.

Bringing it Together

Once you understand the levers in gross margin, you can work out how to combine them.

For example, let’s say you do all of the following:

1. Reduce sales price to $4 per cup

2. Agree lower bean prices ($15 per lb)

3. Launch scones at $5 and sell 500 units per week

4. Improve Gross Margin Conversion; Reduce bean usage by 10lb per week. Reduce disposable cup requirement by 20%. Reduce labor from 80 hours to 40 hours (with a pay increase of $5 per hour).

Let’s see how this looks on the Income Statement:

In this scenario you have increased our gross margin from the base 62% to 69.5%, and gross profit per cup from $3.10 to $3.65. And this is despite reducing the selling price by $1 per cup, which will lead to stronger volumes in the future.

You have made your business more efficient, and reinvested some of that saving into lower selling prices, still earning higher margins overall.

This shows the power of using gross margin levers together to deliver a better result for the customers, and business.

Everyone’s a winner.

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Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend. But I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need to make the right decisions.