Advertisement
 Size doesn’t matter… profits do

Understanding Gross Margin

vince dicecco

Vince is a dynamic and sought-after seminar speaker and author with a unique perspective on business development and management subjects, primarily in the decorated- and promotional-apparel industries. With 20+ years of experience in sales, marketing and training, he is an independent consultant to various decoration businesses looking to profit and sharpen their competitive edge. Visit his website or send an email to Vince@ypbt.com.

It simultaneously amazes and demoralizes me how so few decorated-apparel and promotional-products business owners are familiar with the term “gross profit margin.” In my education classes at The NBM Shows, I regularly poll the audience for how many could define gross margin (GM), calculate its value or know what their business’s GM is. Typically, about 10 percent of attendees’ hands go up. Recently, I posed my usual query to an assemblage of several dozen and guess how many hands arose? Zero… zip… nada. Really? C’mon, people, I beg of you. Wake up and smell the coffee! The health and wellbeing of your enterprise lies in the balance.

Eww, that’s gross

Think of gross profit margin as your company’s pulse. It can easily tell you the health of your business, a particular sale, or a particular product. Some have a strong pulse; others have a weak one. Some have a fast pulse, while some hearts beat slowly. Some people have no pulse at all, a group we usually refer to as dead. Likewise, a business with a near-zero gross margin should have their last will and testament up-to-date. It is just a matter of time before they are out of business. The formula for gross margin is:

Gross Margin = (Gross Sales Revenue – Cost of Goods Sold) ÷ Gross Sales Revenue

Gross Sales Revenue = total money collected from sales

Cost of Goods Sold = total materials and manufacturing labor costs

Simply stated, the gross margin is the difference between the cost to produce something and its selling price, divided by the product’s price, expressed as a percentage. For example, if you sell something for $1 and it costs $0.40 to produce, the gross margin for that product is 60 percent: ($1 – $0.40) ÷ $1 = 0.60 or 60 percent

Healthy margins?

Based on a Philadelphia Investment Firm’s study of all companies in North America, more than three out of every four have a gross margin of between 25 and 40 percent. In my discussions with apparel decorators, the industry average is in the 40 to 60 percent range, with contract printers hovering around the 33 percent mark and most custom shops commanding margins of at least 50 percent. 

No one can tell you, precisely, what your gross margin should be, but you do have one. Make it your business to know exactly what it is and what direction it is heading at any given time. If you are primarily a made-to-order shop and your GM is less than 40 percent, you are under-pricing your goods, leaving money on the table and/or not getting what you deserve.

Locate your company’s most current Consolidated Income Statement, (also known as the Profit & Loss Statement). If your GM is not already calculated and noted, take the Gross Profit figure—the line immediately below the section labeled Cost of Goods Sold—and divide that number by the top line—Gross Revenues (or Total Sales). That is your GM for the period covered by that financial statement. Now, locate previous years’ P & L Statements. Calculate the gross margin for those periods. Is your GM headed up, down or remaining steady over time?

Gross margin versus markup 

Often, I hear markup and gross margin used interchangeably. This is a common misconception. Markup is the percent of a product’s cost that is added to it to come up with a selling price. In the previous example, if that product cost $0.60 to produce and you applied a 50 percent markup (in other words, added $0.30) the selling price would be $0.90. The gross margin for that product would be 33 percent: 

($0.90 – $0.60) ÷ $0.90 = 0.33 or 33 percent

This table shows the relationship of mark-up to a selection of gross margins:

The multiplier associated with a desired gross margin is important to know. If you know how much a product or service costs, you can quickly calculate a profitable selling price using the appropriate multiplier. If you need a multiplier for a GM not listed in the chart, you can determine it using the following formula:

Multiplier = 1 ÷ (1 – Desired GM)

So, the multiplier for 80 percent GM is 5:

1 ÷ (1 – 0.80) = 5

For example, if the COGS for producing 12 T-shirts using your direct-to-substrate printer is $40.20—because each shirt costs $3.35 to make and you want to realize 80 percent GM on that order—charge $201 for that order:

($40.20 x 5) = $16.75 per shirt

On a related note, don’t reveal to customers how easy it may seem to appear to produce a piece of wearable art. Invoke the famous movie line from The Wizard of Oz: “Pay no attention to the man behind the curtain.” If you indicate to the client that it takes no effort or time to print or embroider a garment, you give them no reason to pay a premium—and proper—price for your toil and expertise.

There’s no magic formula for success

There are only two variables that can affect a change in gross margin—the COGS and the price you are charging and collecting for your goods and services. A rise in materiel or labor costs will cause a drop in GM. Consequently, you will need to raise your prices in a timely manner to sustain a healthy gross margin. Making price concessions without lowering the costs to make your wares will also result in a deterioration of gross margin. In this case, you’ll need to learn to master the art of making your prices stick, so you don’t get stuck.

There are no guarantees that you will realize a bottom line net profit by maintaining a desired gross margin for any length of time in your business. Rising fixed expenses—a.k.a. overhead—or out-of-control variable expenses (such as overly-aggressive advertising costs or runaway maintenance charges for equipment) could quickly eat into what gross profit you have been able to capture. With some careful control of the expense items in the lower half of your Profit & Loss Statement, you could turn a handsome profit at the end of your fiscal year.

Contrary to some people’s belief, the primary reason you are in business is to make a buck this year and for many years to come, not merely generate profitless revenue, provide jobs for the economy or to find something for your employees to do with their time. If you think the days of the 1,000-piece order is long gone but your customers only want to pay the 1,000-quantity per piece price, you are going to need to get tougher or risk going out of business. Along this journey of getting into shape and becoming lean and mean, you should find a way to measure your progress toward success easily and often. Remaining aware of your gross margin is simply one indicator—not the only one, mind you—of the overall state of your business’s health. Good luck!

Observation Deck

The following are some observations about today’s marketplace. If you agree with or find yourself having to contend with any one of them, your company’s gross margin is being seriously threatened.

Today’s customer buys less per order than before the ongoing Great Recession. The quantity of garments or number of line items ordered and/or the quality of the piece to be decorated is markedly less than an average order of just three years ago.

Clients and prospects are more likely to ask for price concessions without willingly giving up any aspect of quality, service or delivery, or satisfying volume discount minimums today than ever before.

Over the past several years, the Cost of Goods Sold (COGS)—that is, the direct costs that go into creating the products or providing the services that a company sells (including production labor, materials, manufacturing consumables, packaging and shipping)—has steadily, albeit modestly, risen.

Prices, in general, for most consumer durable goods—such as clothing, electronics and household/school/office supplies—and personal services have either remained the same or has gone down due to heavy competitive price pressure.