So, a few months back I’m guessing you renewed your annual New Year’s resolution to get back into shape. To regain that washboard stomach and shed some poundage, right? But this year, you were really serious. You joined a health club, bought a FitBit, downloaded the MyFitnessPal app, found a reasonable diet, and hired a personal trainer for motivation and guidance, didn’t you? Alas, after a couple of exhausting sessions, succumbing to tempting desserts, and suffering a bruised ego, you slunk back to the couch, grabbed the remote control and devoured your favorite bag of munchies. Tsk, tsk.
You may’ve retired that well-intentioned resolution for another year, but hopefully you made a similar resolution for your business. But you didn’t seek out a personal business coach to help though, did you? Hmm.
That’s where this column comes in: Think of it as your personal business trainer, here to help you uncover the flabby spots, tone up the weak areas and generally ensure that your business is as healthy as it can possibly be. Sound like something that could help? Then, let’s go!
Every good performance-improvement program—whether it’s aimed at your body or your business—begins with an assessment of your current state of fitness, sort of a preliminary physical examination. So please answer the following three questions honestly. Your trainer will be with you shortly…
1. What has your company’s gross margin been over the past 12 months?
- Under 35%
- 35% to 65%
- Over 65%
- I have no idea what my gross margin is or what it should be.
- What’s a gross margin?
2. (True or False) When I mark up my products by 50 percent, I am ensuring my business will enjoy an overall 50 percent gross margin.
3. If I can maintain my target gross margin throughout the year, I should expect to:
- Break even.
- Still lose money because the prices on the street for this industry are too low.
- Make a profit when everything is said and done.
- There is no guarantee to make a net profit based solely on achieving a desired gross margin.
The pulse of your business
If your answer to question 1 was D or E, thank you for your honesty. Sad but true, many business people in the sign marketplace have limited awareness of how gross margin is determined, what their margin is, or what it should be.
Think of gross margin as your business pulse. This “vital sign” can tell you the health of your business, of a particular sale, or of a product line you carry. Some people have a strong, healthy pulse. Others have a slow, weak one. Still others have no pulse at all. We typically refer to this last group as dead. Similarly, a business with a near-zero gross margin should have its Last Will and Testament up to date because it’s not going to be around for very much longer.
The formula for determining gross margin is simple:
Gross Sales Revenue (GSR) minus Cost of Goods Sold (COGS), divided by Gross Sales Revenue (GSR).
GSR - COGS
Gross Margin = --------------------
Gross Sales Revenue is the total money collected from sales; and Cost of Goods Sold is the cost of producing/providing your products and/or services including raw materials, production labor, the cost of subcontracted work, packaging, delivery, and consumables used in the manufacturing process. Anything that goes into the cost of making the product or providing the service you are selling.
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 $10 and it costs $4 to produce, the gross margin on that product is 60 percent:
$10 – $4
--------- = 0.60 or 60%
Recent studies show that more than three-quarters of all businesses in the U.S. enjoy a gross margin between 25 and 40 percent. In my discussions with the owners of sign shops, the rough average in our industry is between 45 percent and 65 percent, with large-volume operations or contract shops hovering around the 35 percent mark and short-run, made-to-order, quick turnaround shops often commanding margins of greater than 65 percent.
No one can tell you precisely what your gross margin should be but, without a doubt, you do have one. Make it your business to know exactly what it is—and be aware of the direction it’s heading—at any given time.
Gross margin vs. mark-up
The answer to the second question is false. Often, I hear “mark-up” and “gross margin” used interchangeably. This is a dangerous misconception. Most people-on-the-street and college marketing textbooks define mark-up as the percentage of a product’s cost that is added to it in order to come up with a selling price. But the mark-up percentage does not equal its gross margin.
In the previous example, if that product costs $4 to produce and you applied a 50 percent mark-up (in other words, added $2) the selling price would be $6, but the gross margin for that product would be 33 percent:
$6 – $4
--------- = 0.33 or 33.3% (Gross Margin)
The table below shows the relationship of mark-up to gross margin:
The multiplier associated with the desired gross margin is important to remember. If you know how much a product or service costs to produce, and want to ensure a specific gross margin, you can quickly calculate a profitable selling price using the appropriate multiplier from the above chart or this formula:
Cost of Goods Sold
Selling Price = --------------------------
1 = Desired GM
Author’s note: I did find one marketing textbook that recognizes two acceptable definitions of mark-up—the one described above and one that defines mark-up and gross margin exactly the same. The logic used to support the latter premise is that if you “mark-up” a product and then later “mark-down” that item by the same percentage, it should take you back to where you began. I think that most people find working with the second definition confusing, so they commonly default to the simpler one.
No magic formula
The correct answer to the third question is D. There are no guarantees that you will realize a bottom-line profit in your business by maintaining a desired gross margin for any length of time. Rising fixed expenses or out-of-control variable expenses (such as excessive spending by your sales and marketing personnel) could quickly erode whatever gross profit you’ve been able to capture. However, with some careful control of the expense items in the lower half of your profit-and-loss statement, you could turn a handsome profit at the end of your fiscal year—profit that can be invested back into your business.
Contrary to what some seem to believe, the primary reason companies are in business is to make a profit—not merely to create jobs to help reduce the unemployment rate, nor to provide something for employees to do with their time. Along this journey that will get your business into the lean and mean shape necessary to turn a profit, we must be able to measure our progress toward success easily and often.
Gross margins may be a mere indicator—and not the only one, mind you—but it’s a critical tell-tale sign of the overall state of your business’s health. Monitor it often, particularly if raw materials costs are fluctuating wildly—as is the case lately with gas prices. Allow the term gross margin to become part of your daily vocabulary. Find ways to maintain and improve it—like raising prices when production costs go up and/or when customer demand rises, reducing manufacturing costs, or adding new products to your marketing mix that command higher margins than you are accustomed to. Good luck!