Strong Margins Will Gear You For Growth

I know it seems like I’m constantly banging on about Cash flow and Gross Margin and that would probably be because I am. Healthy margins and cash flow almost always result in strong businesses that are geared for growth. This is what you should aim to be and hopefully our tips and blog posts are getting you one step closer to this.

To give you some context, we recently conducted a detailed margin review for a client who had experienced a decline in profit despite sales and overhead expenses tracking along as forecasted.

When setting the price point for their products, they calculated that they’d have a 55-60% gross margin (or 40% material costs), approx. 40% in overhead expenses and a net profit margin of approx. 20%. Good healthy financial results, which would result in a self-sustainable business that was cash flow positive and had the ability to invest in further research and development (R&D), whilst continue to aggressively advertise and promote their existing product range.

On paper the forecasts looked great. They were well thought out and appeared to be based on sound calculations. However 6 months into the financial year, things were not running to plan. Sales were strong, with many of their growth projections being met, however gross margin was tracking well below expectation. Instead to tracking along at 60%, the actual gross margin was only 45%. With 40% in overhead expenses, net profit before tax only represented 5% of total sales.

To put it in perspective, on sales of $1m, 5% net profit amounts to $50k before tax. Once tax was taken into account, profit is reduced to $36k.

For this business it meant that cash was tight and required close management to ensure suppliers and employees could be paid. It also meant that they couldn’t invest further in R&D which was how the owners planned to expand the business.

When we asked them what had contributed to the reduction on margin they really couldn’t tell us. In their eyes nothing had changed in the business and there was no reason for the reduction, it had just happened.

At this point we took a deep dive into their gross margin, analysing drivers like:

-          Customer discounts or special offers

-          Foreign Exchange fluctuations

-          Stock write offs

-          Samples and promotional stock

-          Inbound freight and shipping costs

-          Stock prices from suppliers

Following our analysis we found the three main reasons for margin decreases to be:

1.       Substantial increase in air freight - Inadequate minimum stock holdings meant that popular products were regularly running out and instead of increasing the amount of safety stock on hand, they were regularly air freighting stock from Europe and the US to Australia at a premium price.

2.       Not ordering to set minimum order quantities – Many of their supplier agreements included volume based discounts, so the larger the amount of stock they purchased, the lower the purchase price. However as stock control was poor, lots of smaller orders were place (and air freighted to Australia), at much higher prices.

3.       Inconsistent customer discounts – Much like point 2 above, they granted their customers higher discounts for larger orders. However there seemed to be little control around this and even orders that didn’t qualify for discounts were getting them, eating into profit margins.

As a result of our analysis, this client immediately undertook a review of their stock control procedures and systems. They identified their top selling product lines and set minimum holding quantities/safety stock levels. They then placed a large order to build their stock on hand and remove the need to regularly air freight stock. In placing these large orders, it was really important to ensure that they didn’t get into any cash flow trouble, so cash flow was closely tracked and managed both prior to placing the order and in the weeks following.

This measure addressed two of our findings as it also ensured they placed larger orders at planned intervals and qualified for volume discounts.

When it came to customer discounts, they performed a system review and are in the process of implementing an automated solution to ensure no manual input is required to amend volume discounts. In the interim, sales teams are required to obtain management approval for any customer discounts over prescribed levels.

In the three months since these measures were implemented, they’ve seen serious improvement in their gross margin as well as operational performance.

Having a strong grasp on the drivers that impact upon your Gross Margin and ensuring you have counter measures in place to address the negative factors will lead to positive business outcomes on all fronts.

If you’d like some support to review you gross margin or better understand the drivers behind it, touch base with Sarah and myself at info@brambleandbriar.com.au.