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4 Major Factors That Are Responsible For Reducing Your Gross Margin Over Time
Before we proceed, let's be clear you understand what we mean by Gross Margin.
A company's gross margin is the percentage of its revenue that is converted to gross profit. It is calculated by dividing your gross profit amount by your revenue during a given period. For example, if your gross profit is ₦100,000 and your revenue is ₦500,000, your gross margin equals 20 percent. A gross margin that declines over time is cause for concern and should be analyzed to establish the root cause.
If you don't know what your gross margin is, speak with your bookkeeper or accountant. If you don't work with one and don't keep adequate financial records, we can certainly help you rectify this position so you have the right financial data about your business on an ongoing basis. Book a no-fee 15-minutes consultation with one of our Associate Business Doctors to learn more.
Now let's learn about key factors that could be responsible for your declining gross margins:
Higher COGS: Gross profit is calculated as revenue minus cost of goods sold (COGS). COGS includes only those costs that are directly associated with products sold. For example, a manufacturing company would include the costs of raw materials used in production as well as other variable labour and production costs. For resellers, they would include costs of product acquisition and packaging for resale. If these costs should increase with no change in your sale price, your margin will be eroded on each unit of product sold. A supplier charging higher materials costs to manufacturers because of shortages i.e. lower supply in the market, or a manufacturer charging higher prices to resellers, would lead to an increase in COGS for their buyers.
Discounted Sale Prices If your industry or company experiences a dip in consumer demand, you might have to sell items at discounted prices in order to generate sales for a given period. This will result in a reduction in revenue but not necessarily a reduction in COGS. Therefore, you would make less gross profit on each unit sale. One way to tackle this problem is to improve your marketing and sales efforts, increase demand for underperforming products, and return to normal price structures.
Increased Competition If there are more entrants into your industry, this creates increased competition and will generally cause gross margins to fall across the industry. This is because suppliers would now have more buyers to sell to which allows them to raise their prices. Simultaneously, your industry's customers now have more options to pick from, which often leads to across-the-board reduction in prices as companies compete more intensely to win customers and increase market share. The impact is that higher costs and lower prices will end up squeezing margins.
Wastage Declining gross margins can also be as a result of lost, stolen or damaged goods, which add to your COGS but don't generate revenue. These factors, collectively known as shrinkage, can eat into your company's gross profit. Owners/managers must be diligent in keeping shrinkage to a minimum. When you pay for materials, or pay to acquire products that never generate revenue, you effectively throw away money. Inventory control processes and strong marketing and sales can be extremely beneficial in minimizing this problem.
Now you know what could be the reason for your declining gross margin, that's half of the problem solved. It's now time to review your numbers and develop strategies to protect your business' position.
We can help!
We are WNC aka "The Small Business Hospital". We provide entrepreneurs with the practical diagnostics, coaching and consulting services they need to build healthy small & medium enterprises (SMEs), so they can enjoy more life balance and personal freedom.
Why not get started with a Business Health Assessment? Perhaps, you know your business needs to move to the next level but you're not clear on how it's currently performing across different business areas, let alone what needs to be improved, we can run your company through a Business Health Assessment for just ₦3,000 / $6.50 /£5. It's a quick and simple but detailed check-box questionnaire that takes about 10-15 minutes to complete. Once we have your answers, you'll receive your detailed results and prescriptions within 72 hours, via WhatsApp & Email.
Alternatively, our Associate Business Doctors are on-hand to answer any questions you might have and share more with you about how we can help your business based on its current situation or which of our coaching packages could work for you.