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Gross Margin is about dollars, not percentage

Posted by Tom LarsenNov 5, 2014 Marketing, Operations, Planning, Product Development 0

There is the perspective that runs around that achieving certain gross margin percentages make a business viable. There is no doubt that higher margins are better than lower margins. What I tend to hear though is that if XX% is achieved, all is well for the future, which is entirely the wrong approach to understanding your business.

Let’s spend a minute going through the math basics (sorry, if you hated math in school, but, you’re running a business). If you’re selling a low price item, say $10 at a 40% gross margin, that means 4 out of every 10 dollars goes toward your discretional expenses like marketing, overhead, paying yourself, paying sales people, etc. If you can reduce the costs to produce the item to $3 instead of the $6, that would mean 7 out of every 10 dollars collected goes to expenses. Clearly 70% is better than 40%.

What is truly important though, is how many dollars your company needs to sustain and how much reach your company has to get those sales.

For every 1000 transactions at $10, in the best case above at 70% Gross Margin, the company creates $7000. Awesome; maybe. Can you create 1000 transactions at $10? Does $7,000 cover everything? What if you only create 500 transactions? What if you need $10,000.

By stark contrast in a different scenario, if you are selling $50 items at 40% gross margin, to create the same $7000 of gross margin, you only need to sell 350 items. It is likely far less actual work to find 350 customers than to find 1000 customers.

There is an adage that you pay your bills with dollars and not percentages. Do the math and be really confident about how many actual TRANSACTIONS (wholesale or retail-you still need consumers) you will need to create in order to make any money in margin dollars. The easiest way to go out of business is to have lots of transactions for really high margins at really low prices, but, not enough to sustain the business. When someone gives you a “rule of thumb”, be sure they are also telling you at what price and what overhead costs, those are controllable numbers!

There is NO silver bullet. The savvy business person knows the numbers they are working to achieve for the outcome they seek. The percentages are like a tachometer in your car; at best a tachometer can tell you how hard your engine is working. It won’t tell you how fast you’re going or how soon you will achieve your destination, which is actually what you care about.

BTW, the tachometer is irrelevant enough in automobiles that many don’t even have them anymore.

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