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28 March 2024

Gross margins: Golden Goose of business

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By Amanda Line
Profitability is the primary aim of all business managers, but how can you evaluate it? No business performance measure is more universally recognised than the gross margin. The higher the gross margin, the more profit can be made. It also acts as a robust means of comparison for different businesses, across both sectors and country borders.
Calculating gross margins
Gross margin is calculated by subtracting the direct cost of sales from the value of sales. For example, a business with monthly sales of $20,000 but costs of $12,000 has a gross margin of $8,000, or 40 per cent. This in turn becomes a mechanism for calculating profitability; deducting overheads from gross margin gives net profit. As overheads are usually fixed in the short term gross margin is a key indicator of profitability.  
However, it is also a great measure for comparing businesses across industries and economies. Regardless of the sector, a business with a gross margin of 20 per cent must sell two and a half times as much to achieve the same value as a company with a 50 per cent gross margin. This means it becomes easy to make swift and reliable cross-sector comparisons without having to adjust for variables like currency or sector-specific issues.  
Since the financial crisis, there has been intense pressure on gross margins in the Middle East. Falling demand across sectors has made it difficult to maintain gross margins and businesses have had to reduce selling prices, which in turn damages the bottom line.  
Improving gross margins
Increasing selling prices
Businesses always face price constraints, usually dictated by costs and typical selling prices. However, the most influential factor is usually “what traffic will bear.” For retailers, location is important: proximity to competitors, and whether they command a regular customer base or are dependent on ‘one-offs’. However there are opportunities – such as product shortages – that can allow temporary or permanent increases. It can be worthwhile increasing prices, at least on selected lines, to establish the effect on demand.  
Reducing the cost of purchased direct materials  
Reducing costs of input prices depends largely on ‘leverage’ over suppliers. Major customers can secure significant discounts. Small customers representing insignificant shares of supplier sales are unlikely to be able to negotiate much on price. However, when margins are tight and cash flow is an issue, suppliers are less able to offer credit. This means that offering cash on delivery can mean being able to negotiate a discount. Alternatively, belonging to organisations that bulk buy – either big chains or consortiums – can help in negotiating prices down.  
Improving the sales mix
Products that offer greater gross margins will always be better for overall gross margins. However, if new products can be introduced with even higher gross margins without increasing overheads this is clearly beneficial. When looking to build overall margins it is most important to focus resources on areas of the business that offer the greatest return for investment. This means understanding which product lines offer the highest margin and adjusting the product mix to suit.  
Reducing waste, write-offs and pilferage of stock
This is an area where most companies can make significant gains. Pilferage is estimated to represent 2 per cent of retail business turnover. Eliminating this represents a potential increase of over 10 per cent in the gross margin! It is therefore worth considering all the security measures available.
Careful planning and forecasting are also crucial
Production or sourcing levels must be sufficient to meet demand but not so high that companies have to offer discounts to shift unsold goods or to throw out date-dependent stock. The economic crisis has meant that accurate forecasting has become hugely challenging for many businesses leading to price reductions and discounts to shift unsold stock. As the economy stabilises this will become less volatile, and accurate planning will become a vital skill in order to meet – but not exceed – demand. 
Introducing new lines or services
Businesses should regularly review all major lines including what proportion of sales the product represents and what the contribution is to the gross margin. Questions to ask include: should lines with lower gross margins be dropped? Could other lines be introduced with higher margin? What would customer reaction be?  
Would it bring new customers? Are there any other consequences? Middle Eastern businesses have demonstrated great flexibility during the financial crisis, and showed business models could be adapted to maintain profitability despite market place uncertainty.  
Although business managers know their own company best it can be worth consulting outside financial experts such as chartered accountants who can offer an impartial view and detect trends within the business from an onlooker’s perspective. Whatever the economic situation, gross margin will always be a key indicator worth watching.
The author is Regional Director, ICAEW Middle East. ICAEW is an accountancy and finance body [Middleeast@icaew.com]