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Evaluating Insufficient Gross Profit — 

Do you ever read your income statement and wonder why your gross profit seems to lag expectations? The popular belief is that gross profit is largely affected by pricing strategies. While it is true that pricing has a lot to do with your level of gross profit, there are usually other factors at work as well.

To deal with insufficient gross profit, look at these factors:

1. Pricing. How do you currently price your product(s) or service(s)? What are your pricing strategies based on? Are you simply taking your cost and adding a markup or mark-on to it? How much do you know about the price sensitivity of your market(s)? How much do you know about your competitors' pricing? Do you have any sort of competitive advantage in terms of product or service superiority or some unique market position that could justify a higher price than your competitors' prices? Is yours considered a commodity product or service? Have all true costs been factored in prior to setting prices? These and other questions point out that setting prices is not as simple as tacking on some arbitrary percentage or flat amount to your cost. You must understand your market well and have a good feel for where demand becomes sensitive to changes in pricing. Through market research, sales force feedback (careful here because sales people tend to want products/services priced lower than competition to reduce the amount of resistance they have to deal with), market testing and other means prices can be more accurately established. Ask yourself this question: if we raised our prices by 1%, for example, how much negative impact would that really have on demand? Then calculate the impact of a 1% increase in price on gross profit. Let's look at an example: Suppose you are selling a product at $25. Adding a 1% increase makes the new price $25.25. Let's suppose the true cost of that product is $18. Your gross profit before the 1% increase was $7 or 28%. After the price increase, the gross profit is $7.25 or 28.7%. Let's further suppose that your sales volume for that product is 5,000 units. Prior to the price increase your total gross profit on that product was $35,000. After the price increase, your gross profit was $36,250. What if your sales volume was 100,000 units? Prior to the price increase your gross profit was $700,000. After the price increase it was $725,000. All of this begs the question; how will volume be impacted by a negligible price increase? In most cases, very little. The point here is that businesses very often "leave money on the table" by not charging a high enough price. Look at the prices of all of your products and services and carefully analyze the impact of small increases on both demand and overall gross profit. Too many organizations follow a low-price strategy because they believe they can drive volume significantly higher with such a strategy. While this is sometimes a good strategy, especially during product/service introductions (not always however), it is rarely a good long-term strategy.

2. Product/Service Mix. If you are offering multiple products or services with different gross profit structures, it is important to understand that how you manage the sales of those products or services can have a major impact on overall gross profit. If your product/service mix (weighting of sales by product or service) is weighted heavily toward lower gross profit items, overall gross profit will suffer. Our objective is to shift the product/service mix toward higher gross profit products or services. The following example shows how a shift in product mix can impact overall gross profit:

Scenario One:

Product A price=$50; gross profit margin=19%; sales=20,000 units; percent of total sales dollars=41%

Product B price=$65; gross profit margin=26%; sales=15,000 units; percent of total sales dollars=40%

Product C price=$45; gross profit margin=33%; sales=10,000 units; percent of total sales dollars=19%

Total sales = 45,000 units; $2,425,000

Overall gross profit = $592,000

Overall ("Pooled") gross profit margin = 24.4%

Now let's assume we have "managed" our gross profits a little and the numbers now look like this:

Scenario Two: (prices and gross profit margins remain unchanged from scenario one; total sales in dollars held constant)

Product A sales=12,000 units; $485,000; 20% of total sales dollars

Product B sales=17,000 units; $1,105,000; 45% of total sales dollars

Product C sales=18,555 units; $835,000; 35% of total sales dollars

Total sales = 47,555 units; $2,425,000

Overall gross profit = $676,842

Overall ("pooled") gross profit margin = 28%

In this example, total sales in dollars remained exactly the same as in scenario one. The number of total units sold increased because the lowest priced product, product C made up 35% of total sales in scenario two versus 19% in scenario one. But because products B and C, both of which had significantly higher gross profit margins, made up much larger portions of total sales in scenario two, overall gross profit increased by nearly $85,000 and 4 points over scenario one.

What implications does this example have for your business? What this points out is the fact that gross profits must be consciously managed. This is done through education of the sales force, providing incentives to the sales force, running short-term promotions to stimulate trial of higher gross profit items, seeking price concessions from product vendors if you are in the distribution or retail industry, shifting advertising dollars from promoting low gross profit items to higher gross profit items and education of your customers and prospective customers.

Obviously, product/service mix management is not as black and white as we make it out to be in this brief discussion. There are a number of situations that require different plans of attack and strategies. But we believe it is critical that product/service mix be managed to the extent possible.

3. Purchasing. There is no question that how well a business buys raw materials, products, parts or supplies that are direct product/service costs has a tremendous impact on the bottom line. It is important to regularly review your purchasing practices and contracts or agreements with vendors. All too frequently, employees who are involved with purchasing activities don't negotiate the best possible price with their vendors. Make sure that purchasing personnel understand the company's profit objectives by product line and provide them with the opportunity to enhance their negotiation skills. In a number of cases, the vendor has done everything they can do in terms of discount structure or flat pricing. But they will very often participate in special promotions with short-term price concessions. Visit with each vendor about your promotional plans and let them know you want them to participate. Remember, as long as you are reasonable, they will work with you. They have the same objective you have and that is to move product. Also, take advantage of vendors' promotional money and programs. They can very often reduce your expense associated with advertising and promotion. In short, make certain that you and your purchasing staff are paying close attention to vendors. Work them like they work you. If your people develop solid working relationships with them, the vendors will often give just a little more when setting prices for you.

4. Other Factors. A major culprit in insufficient gross profits can be your sales force. This is generally only true when they have the ability to set prices or negotiate contracts. Sales reps are notorious for "leaving money on the table". Give your reps strict guidelines about pricing. Any deviation from these guidelines must be approved by the sales manager or some other key management person.

Also, if you are running promotions that are based on price reductions, what kind of results are you getting? Are you seeing significant increases in sales during those promotions? If not, why? Is your reduction too small? Is your product/service not price sensitive in the market? Are your promotional efforts in terms of advertising or other means effective? Sometimes businesses run price promotions too frequently or when they really don't need to. Unless you are realizing a significant increase in sales and trial of your product or service during or immediately following these promotions, why concede gross profit on those sales you would have had without the promotion?

And if you are in the service business, do you find yourself writing down invoice amounts due to poor service or shoddy workmanship? If so, you have other issues to deal with. But remember that writing down an invoice amount shouldn't be automatic. In some cases, it will be so obvious you won't have any choice, but in many situations the write down might not be justified or shouldn't be as significant as proposed.

In summary, look closely at your gross profit. Assuming your expenses are not out of line, is it sufficient to provide a reasonable net income?

 

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