Strategic steps to GM heaven

2007-11-27 00:00

Last week we looked at all the considerations involved in making less turnover more profitable — to the required level.

You will recall that the business we were evaluating, “MyCo”, has an annual turnover of R7,5 million, which produces R700 000 PBT (profit before tax). By reducing the operating overhead by R200 000 pa and improving the gross margin (GM) percentage from 40% to 44%, we are able to produce the same PBT from R1 million less turnover. Of course, if the top line did not fall away to this extent, then this new strategy would simply produce more profit than planned.

The operating cost-saving exercise is a relatively easy one. To all intents, you will have looked at all your overhead costs and any you find that are not “adding true value”, you are saying must go.

The element of the new strategy I need to spend more time on is related to finding ways of improving the gross margin percentage by four percentage points.

The lifeblood of any business is gross margin. This is not to say that turnover is unimportant, but rather that the gross margin value of that turnover is vital to the business’s profitable health. MyCo’s new strategy means that an additional four percentage points of gross margin will need to be found.

Let me set you a small test. Put down your Witness and answer the following question: There are only three ways by which to improve gross margin — what are they?

Over the years, I have found more ignorance across management in relation to gross margin than any other aspect of business practice and, I might add, this lack of knowledge and understanding is all too often extremely costly to the business.

I hope that your answers to my question were something like this: 1. Increase the price; 2. Reduce the variable costs (costs of sale) and 3. Change the sales mix. MyCo’s search for four percent GM improvement would more than likely be found in a combination of all three methods.

First and foremost — the price increase. You must remember that I am suggesting you increase price solely to improve the GM percentage — not just to recover extra costs.

Many of you will probably be exclaiming, “If I do that, I will lose turnover!” So what? The strategy, remember, is designed to accommodate the loss of R1 million turnover. Perhaps more importantly, you don’t know (for a fact) that you are going to lose turnover.

You feel you will mainly because of a natural fear of price. If this is the case, you need to change your attitude towards price. Remember, it is the gross margin value of turnover that will pay your bills and make you a profit, not turnover per se.

Reducing the cost of sales or variable costs can be achieved in a number of ways, particularly if you are in manufacturing and selling products. Let’s begin with an attitude change, namely, to “screw” your suppliers on price, just as your customers are, more than likely, doing to you! Set yourself clear objectives and identify those costs of sales that are formidable and look for all ways to reduce them — it is that simple.

Even if you can only bring the total cost of sales down by say one percent, the effect on the GM is dramatic. Apart from buying better — less expensively — you can reduce the cost of sales by using less stock, producing less waste, cracking down on theft, etcetera. Anything that reduces your costs of sales without impinging on quality will have the effect of improving the gross margin percentage.

The last consideration of the trio is changing the sales mix. Most businesses have many products, all reflecting a different gross margin. Your monthly operating gross margin percentage reflected in your management accounts relates to the mix of sales achieved in that particular month.

One of the very best ways of improving GM is to improve the sales mix.

In other words, finding ways to make and sell more of the higher gross margin products at the expense of the lower ones. The effect: gross margin improvement.

The most important consideration of last week’s column was for you to strategise to make lower levels of volume more profitable. Here in South Africa, if the economy gets a cold, many, many companies die from chronic pneumonia.

It makes such good sense for you to look analytically at your business and proactively design a strategy that makes tomorrow less stressful and more conducive to producing the profit you need.

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