Gross Margin Doesn’t Live Here Anymore – How Does This Affect Bottom Line Profit?
Remember the time when all wholesale manufacturer’s prices were accompanied by the user-friendly statement, “suggested list price”? In some cases the statement is still present, but the user can no longer use it! How does the Gross Margin affect the bottom line Profit?
The small business operator could simply ticket his products, knowing the list price included a comfortable Gross Margin – all worked out by the manufacturer to make a necessary bottom line Profit. Ah, the good old days!
With the advent of the mega discount stores of the past decades, one is often left puzzled with the question: “how can they sell it for so low a price when there is no more Gross Margin?”
Of course the answer is found in the volume and competition. The Gross Margin is cut to a bare minimum percentage ratio that leaves just enough to cover operating expenses – if at all. Bottom line Profits are consequently reduced.
Depending on the type of business, some are more affected than others, and of course, now, we have a whole different set of rules again with the Internet business, particularly in the area of digital products.
Some time ago, I was discussing this subject with a young entrepreneur who operates a small manufacturing business. He could not understand the issue, insisting the solution was found in getting better prices on raw materials and overhead costs.
That is obvious, of course. Making Profit has always been a matter of keeping overhead and expenses down. But he had no idea what Gross Margin was on an operating statement.
There was a time when the price of the product or service was standard pretty well everywhere you went. In the last twenty-thirty years, there has been an increasingly eroding effect on “list prices”. Often loss leaders have become the pace setters of today’s pricing.
John Doe Electrical Company decides to put forth a selling motion 20% below standard industry prices. The buyer picks up on that and eventually expects or demands the same from Electrical Co. #2 and #3, and all the rest of them have to follow suit.
As a matter of fact, today, companies offer a “we will not be undersold” policy that will refund the difference if you see the same product somewhere else at a lower price. And many will even add to the refund another 5%! Unfortunately the small business cannot compete with the margins of the mega box stores.
Over decades, the spiraling of the selling prices created a thinning of the built-in pre-calculated mark-up costs. There comes a point when the selling price dictated by the indiscriminate competition no longer supports the wisdom of the purchasing powers of raw materials and direct overhead costs.
Take for example the fascinating case of the computer retail and service industry. A few years ago, a graphics house could get its linotronic outputs at a service bureau for $18.00. Then someone else advertised them for $15. That became $12. Soon it was $8, $7 and even $6. True story. This last rate held steady for many years until this early technology was replaced. But the machines doing the output were still in the same price range to buy.
How much output does any service need to spit out per month, in order to cover the equipment investment, considering the average output takes about half an hour, and more if there are technical problems to deal with, plus labor? The suggested list price was calculated at $18 by common business accounting practice and included Gross margin and bottom line Profit. Now it has been knocked down to $6 or less!
What does this all mean?
Companies are making less and less. They have to run increasingly leaner; but where does that lead to when it runs out of meat? Dry bones! Less bottom line Profit. Job cutting. Employee cut back.
There are of course new waves of technological companies that show healthy ratios of pricing, costing and profit making. The gap between those and the traditional businesses, as we have known them during the industrial revolution, has grown bigger in this information/technology revolution age.
Gross Margin doesn’t live here anymore. She has been run over by tumbling selling prices. May be one day, even her very trace will be erased altogether from the standard financial statements of conventional businesses because there will no longer be a place for her. Or has that already happened? Who’s even searching for Gross Margin anymore? Bottom line Profit has to thrive alone now.