Gross margin is one of the most important numbers in your business.

Gross Margin (percentage) is a good indicator that your business is healthy: Both on the selling/strategy end indicating your customer is willing to pay you well for what you offer, and on the operations end demonstrating that you can efficiently produce what the customer wants.

The trend of this number over time can tell quite the story. When it starts to fade, as it often can, it is a reason for concern. 

This week we talk about Gross Margin erosion, why it happens and what you should do if you find yourself in this situation.

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EPISODE TRANSCRIPT

Please note that this episode was transcribed using an AI application and may not be 100% grammatically correct – but it will still allow you to scan the episode for key content.

 

Brad Giles  00:13

Hi, welcome to the growth whispers where everything we talk about is building enduring great companies, companies that last that endure. And companies that actually people enjoy owning and working in. My name is Brad Giles. And today as always, I’m joined by my co host, Kevin Lawrence. Good. Oh, Kevin, how are things today?

Kevin Lawrence  00:32

Things are great Brad. Just settling in here and into still in our winter season. But yeah, good. Come forward to the week got a very busy week ahead and looking forward to the show today.

Brad Giles  00:46

Me too. Me too. One of in the absolute business nerd perspective. One of my favorite subjects, gross margin, but we always like to start with a word or phrase of the day. What might be on your mind in terms of a word or phrase today GIF?

Kevin Lawrence  01:04

that, hey, it’s ramen. I you know, growing up as a kid, we’d have these instant ramen noodles is something you can make when mum or dad wasn’t around to cook. Yeah. And I thought ramen was like, right up there with Kraft dinner like we would have what here in North America. And I went out and had a ramen on the weekend. And it blew my mind. Like it was absolutely incredible. And I think the principle of it is just, it’s just how at any stage of life, you can be opened up to new experiences that you never thought so it’s not so much with the ramen. It was outstanding. It was in Chinatown in Vancouver was amazing place. It was called the ramen Butcher. And it was it was but it was more that there’s so many different experiences, perspectives and things in the world. That that, that we can be surprised by things pleasantly surprised.

Brad Giles  02:00

Awesome. Awesome. For me, friend actually asked me he said what’s your word for 2023. And I don’t really get into that stuff. But I felt obliged. His was adventure. But mine was compound to compound and compound and can continue to compound things that are working and make them better. And it felt right. And it still feels right if there is such a thing, but for me, yeah, what’s my word or phrase is compounding so

Kevin Lawrence  02:30

compound that’s very practical bread compound, compounding flavors of ramen. Maybe that sounds like I can’t wait those two together. Let’s move on.

Brad Giles  02:40

Very good. All right. So today we’re talking about gross margin. Oh, we How awesome is gross margin when it’s working well, and how much of a pain in the butt is that when it’s not working? Well, today, the question that we’re asking is my gross margin is dropping, what should I do?

Kevin Lawrence  02:59

Yeah, you shouldn’t you need to do something. And here the thing is, is you know we talk about often it’s it’s one of the most important numbers in business because it indicates business health, and indicates the health of the front end. And it’d be able the ability to sell to customers at pricing that is ideally, you know, premium in some way, depending on your business model so that you’re getting the right pricing in the market, you’ve got a competitive advantage allows you to price well. And then also, you’ve got an operational advantage that you’re able to buy or build inexpensively, which leaves a gap between the two. So it’s the marrying of operations and sales, it that gross margin tells you that they’re both doing exceptional or somebody could be doing an extra exceptional job. But it tells you that that there’s a lot of good things that are happening at a macro level before you zoom in. And the trend of this number can really guide us on what’s going on. We look at it all the time in businesses. There’s more to it than just that. But when it’s going well or when it’s not. It’s something that deserves our attention and worth digging into to figure it out. Yeah, and it can be figured out.

Brad Giles  04:16

And it kind of determines the effectiveness of the strategy and the leadership team. Obviously the you know, there’s, it’s demonstrative in one way of a lack of discipline, discipline, but very much. If your strategy is effective, you should have a healthy gross margin.

Kevin Lawrence  04:38

Yeah, well, yes. The especially the front end competitive strategy on the selling part of it. Yeah. But your operations team could be having all kinds of problems and messing it up once the business comes in and out. So no matter what it’s important, for example, a company that this is going back, Gosh, 15 years ago, a company that was in a commodity business. So that’s the way most people looked at it. And we were able to take that business from about 18% gross margin to 28. And even at the point we had the whole team rallied around getting the gross margin. And if we hit it, the whole team and their partners got to go to Mexico for a celebration, which we did. So I will never forget that one. But

Brad Giles  05:29

I mean, that’s awesome. 18 to 28. That is remarkable. Remarkable. They

Kevin Lawrence  05:37

Yes. And to this day, when I talked to people in that industry, and I said, Yeah, we worked with one that did 28, they shake their head, like how. And as we went into it, what it became is that we had this one sales guy, interestingly, we were recruiting him for three years. So the CEO was recruiting him for three years. And he came in, he had a way to do all kinds of extra services outside the core product was, we’ll call it commodity. Yeah. And he had all animals and limb and no control of pricing, because they were distributing a product, basically. But this guy had this model where he had all kinds of additional services, while we’re in there doing what you need, they would do all this other stuff. And with great service, and the customer was thrilled somebody was getting it done. And was not concerned on the margin on the stuff that wasn’t in the core commodity space. The accountants could line up and the purchasers could line up pricing on the core commodity stuff, not the other. Yeah. And it was so they transition to the whole business. It was amazing. Absolutely amazing.

Brad Giles  06:41

That yeah, that’s a an outlier story. Because it’s such a huge difference. So congratulations. I remember what the

Kevin Lawrence  06:50

levers the what they did, yeah, the principles that they use to get there anyone can use to look for the higher margin pockets of things that they can make more money on, while serving the customer and the customers thrilled.

Brad Giles  07:06

And it’s worthy of effort, no doubt, I remember we there was a retailer that we’re working with their gross margin, it used to be 48%, for a retailer, is probably average, maybe medium to average. And we got it up to 52% over successive years. And then we had a yearly and a quarterly theme to drive it from 52 to 54, which was a huge change, because broadly for them, that 2% of revenue fell straight to the bottom line. Yes. It’s remarkable.

Kevin Lawrence  07:43

We also had one with a retailer where we did a quarterly theme. And it was I believe it was just one was the theme, just one. And it was a luxury goods organization. And, you know, a lot of high end department stores and high end shops. And the idea was and what the head of retail would say is, you know, if we can get the customer to buy one extra lipstick, that incremental extra sale on a extra high margin product, lipstick had a very high margin for them. It was it was driving incremental sale of an incremental or of a project that had above average margin. And again, we had a whole theme go through the whole org whole organization thinking about it. Obviously, it adds up quite well at the end.

Brad Giles  08:31

That reminds me of McDonald’s, maybe not so much today, but several years ago the saying going around was that the question Would you like fries with that actually was responsible for 100% of their profit. Basically, all of their profit at the p&l level was coming because of that upsell in the transaction? Rather than just Yes, I’d like a hamburger or whatever it might be. And that’s what you’re saying is looking for the upsell opportunities to increase the overall gross margin because really chips fries potatoes that are fried and I have a very good gross margin.

Kevin Lawrence  09:12

Yes and there’s two things that are happening they’re not only hope probably improving the overall gross margin percentage because of the mix selling more higher margin products but to their increasing the total bucket of gross margin dollars with the extra sales so that that they’re called compounding while you’re just waiting you had that teed up Hey, that was all it is compounding is it’s it’s a double whammy on the gross margin, a higher margin product theoretically if the potatoes indeed are and more margin dollars. And yeah, there’s two levers that make a big, big difference. That’s why for example, when you go to like an athletic shoe stores, and when I was growing up as a kid, they always had the bins of socks Yeah, right there by the till. And they always have those ceiling things you can spray on your shoes, which do they work? Or do they not? I don’t know. Yeah. But what I do know is they have big fat margins. So not only do they have massive gross margin percentages, it’s incremental dollar. So those add on sale. So these are all things to look at. And that’s where things start to fall apart. I mean, in those companies, you could never leave it without them offering you both of those things. And maybe it’s still the same way today, I

Brad Giles  10:28

don’t know, another quick way that retailers do what is called the snake. So as you approach the till to pay, there’s a waiting line. And that’s decorated with all sorts of smaller incidentals like perhaps chewing gum, or lollies or whatever it might be that you might want to buy to increase the average dollar sale. But also, these are often very high margin products.

Kevin Lawrence  10:55

I saw a brilliant one today I bought some tickets on Ticketmaster, my son and I are going on a trip and we bought tickets to a show. And as I’m doing the checkout this one no, it was a different transaction on it during the checkout for the tickets. It’s offering me Oh, you’ve got, you’ve just earned a free blank from HelloFresh a free meal kit. To get it, you just earned a discount. So this is Ticketmaster. But they are now offering me if I had four other things, I had to click no to on the way out, because that each of those is worth more dollars to them. And this has nothing to do with the core product, which I thought was really interesting.

Brad Giles  11:38

Well, it’s just a referral fee, but that referral fee is 100% Gross Margin

Kevin Lawrence  11:45

100% Because there’s no cost involved. Exactly. So there’s lots of different examples. Same thing when you book, you know, hotel rooms or flights, and then they offer you insurance and all these other things, these, you know, those add on sales are a, a really, really big piece, you know, another company we worked with, and we also increased it fairly substantial. I’m a big fan of gross margin because again, it shows how smart and effective the team is. Yeah. And you know, in this one, we took it and it was mid 20s. And we got it on average just over 30. So say 25 to 31. In that range. I don’t have the exact numbers here. But that is at least that, again, considered a commodity type business. And we insure we got this, this consultant working with us, just to help us on higher margin sales strategies, and finding big margin pockets. And that there’s it’s the hunt, the hunt for where there’s more margin, and we found a way to sell at a slightly higher price. And then at some cases, we found a way to dramatically lower our input cost, like dramatically. Yeah, and and it was it was it was awesome. But the thing that made the difference, really is that, you know, they and they have a lot of salespeople, you know, maybe at that time was 100. Now it’s a couple 100. But a lot of salespeople, and we just were training the salespeople, the salespeople are paid on margin. So they have that, right. That’s a big piece. If if the pricing is flexible, but we just had this thing where they would put in the sale price and the cost, and it would give them red, yellow, or green if the margin was good. Like a lot of salespeople aren’t mathematicians. Yeah, their relationship people, and they may or may not even understand margin or how to calculate it. But we made this basic calculator that they had to submit with every deal. Yeah. And basically, it’s like, how would you just play with the numbers until it’s green? Because if it’s not green, your boss can’t approve it or there has to be work. And so they could just they could take the price up because it was a lot of units. They could take the price up 75 cents, and they’d be green, and they can raise margin a few points. Yeah, that was it was very simple. So we educated the salespeople, we had the CFO educating them, we armed them with this tool. And we also created a theme around it and no problem driving it. And it moves around sometimes depending on what’s going on. It also moves around with a mix of business, but I will tell you, one of those pockets of profit that we found was so good. It distorted the entire income statement. That means the margin the gross margin was so high again, that one those ones were what the 40s in the 40s in an industry that’s in the 20s Yeah, and massive projects of massive dollars. And it actually created a problem because that because it was so good because the income statement started to look better than it was in the other areas because it’s a story.

Brad Giles  14:46

Yeah, we I’ve done similar things with a company asking a team what was your gross margin percentage last year, either company or department depending on the breakup of products and stuff? It was, let’s say it was 52%. Last year, well, let’s set that as being the bottom of green. And then we’ll, for the sales team will go up 5% Is the green bandwidth, so 52 to 57, then anything above 57 is super green, then reverting 50 to minus 547 is Ember and anything below 47 is red. And that using that discipline is bound to increase to the question of the episode, our gross margin, if we can adhere to that discipline, and I love what you do, we do the same thing, which is, if you’re going anything outside of green, or super green, you need to get your manager to sign that off in writing,

Kevin Lawrence  15:43

building discipline and deal because at the end of the day, I’m a salesperson, and I’m gonna, I’m making up numbers here, but I’m gonna close, you know, a $250,000 deal. And, and I’m gonna get, you know, 10 or 15, grand 10 grand a commission, whether the margins A plus A point or minus a point, unfortunately, doesn’t affect me dramatically in most comp models, even if you’re paid on margin. So I might get eight grand, instead of 10, grand or 12. Grand. And for a lot of people, they’ll take the aid if they can, because in their world, it could be significant. Yeah, where the company is losing a lot of margin dollars. So, so building those discipline and rigor into it is is key. I’ll give you an example. I got one company that, you know, we had two major product lines in a business. And the business was started based on 140 years ago. And it was basically wood and metal. And we couldn’t find a way to be competitive on the wood side of the business and the main and, and that’s where the business was founded. It was the heart and soul and the passion. And we sold it off. And we ran with a metal side, because we could now it took a few years, obviously, it was a big change. But there was no way that we could see that we could continue to scale and get better margins and based on who our competitors were, and the and the structure of the industry. And maybe it was possible, we couldn’t see it. So we phased that out, stuck to the metal side, which had more growth, and at notably better margins for us based on our dynamic. So doesn’t mean that it always works. Sometimes you got to make a change. And that’s the hard part. But we least we got to knowing the answer. We did this book called islands of profit islands of profit and a sea of red ink, which teaches you to break your business down granularly by gross margin, and then allocate a proportionally overhead costs based on the amount of energy or time and resource it consumes. So you’re really looking at a more sophisticated or a profitability per model. And again, it was a lot of work. But with the insights we had, we knew we had to do it, it just was time to get the point of it being it sometimes you’re not the person to make it work based on how an industry is structured or whatever’s going on. Well, a

Brad Giles  18:13

couple of points. There’s a team that I’ve worked with, we needed to pivot the business, we went through this question. And basically, it was a b2c customer b2c industry. And it was funded by the government. And of course, government decides to spend money elsewhere. And so they’re just driving down and down and down all of the income that they’re getting. But the wages are continuing to go up. So we over a multi year period decided to pivot to B to C. And the gross margins were two and a half times higher. Wow, per hour because it was service. It was just outrageous. Yeah. And so the compelling case was there. But it was founded in that all of those things, I guess, two of the really important points is that no one owns gross margin percentage, often in a company. Okay, so you might have a sales manager, for example, where a VP of Sales who is accountable for the total gross margin dollars to budget if you’re doing well, but who is accountable for gross margin percentage, it’s it’s not that common in small and medium business that someone has actually and so it kind of falls back to strategic days or waiting until we notice an erosion or something like that. And so that can be this, this happened actually with a retailer. The second point for them and this is the second point that I’m making, and you kind of alluded to this before is that the salespeople were compensated on revenue, so salespeople were compensated on revenue number one on. And so the more revenue they sold, the more basically personal comp they made. But also there’s nobody accountable or even owning or watching gross margin percentage. And those two things together can create the situation that we’re talking about here, which is your gross margin is dropping, what do I do?

Kevin Lawrence  20:20

Yeah, and it’s interesting, and you’re saying there, but I mean, obviously like, and the key point about ownership or sales people’s comp, if salespeople can control pricing and discounting, if they’re allowed to move the numbers, it’s pretty important that they’re connected to gross margin on a comp. If the pricing is solid, and they can’t touch it, you can pay them on revenue, because they can’t influence it. But there was a really key point in what you were saying there on gross margin, we often find, because the gross margin is a combination of a lot of variables. So in a lot of companies, we will make the salesperson accountable for selling margin, which is a theoretical margin, it’s what we believe will make based on our understanding of our cost base, so we’ll report sales margin. And then on operations, it’ll be production margin, if we’re making stuff. So we kind of split up kind of split it apart because of different things, pieces of control on what was the other company we had, we had sales were both and even at another retailer, we would the buyers, would we would be the buy the buy in margin, what we bought it out. And we were also manage them on the sell through margin. So the buying is what we purchased it. But if the buyers bought a lot of stuff that didn’t sell them at the DAS discount later, we also tagged them with that. Yeah, because if you bought and it didn’t sell sure you bought it at 80% margin congrats. But in the end, we only got 42, because we had to practically give it away. You know. So it’s it’s very, as companies get bigger, it gets complex. But let’s just go through a few of the key themes you’ve touched on, we made a list of a few things for people to think about. And we’ve talked touched on one of these stories, but like one is line by line analysis over a long period of time, I like to look back five years, yep. Because when you’re when something’s going wrong, either margin, I like to look a minimum of five years of history data. And what we want to look for is as a percentage, by customer by product by region by Sales Team graphed with five years of data so we can see what’s going on and visualize the data.

Brad Giles  22:30

So this is the first thing to do this is absolutely,

Kevin Lawrence  22:33

you got to start What’s the truth? Otherwise? It’s just an opinion. What are the facts? Yep? What are the for sure. And then also watch for any little pockets where people can hide, you know, discounts or stuff like that sometimes, you know, one company that, you know, they can offer shipping. So we had to build the shipping into something because salespeople control that. So basically, understanding all the levers, understanding pricing, as we talked about, we talked about that in episode 148. About pricing, but pricing, discounting. Now how salespeople are paid, we talked about it and do your salespeople understand margin a lot don’t. Because they just haven’t been trained on operations costs. Looking at those. After the salespeople brought the business and look at all those costs as a percentage of revenue. Sometimes you got to look at the overhead they absorb too. Because you know another company I work with they have they generally operate in the 32% 34% margin. But they have a product line that operates at 12% margin. But it’s highly profitable, because they don’t even touch it. It’s a paper transaction. There’s no overhead really, yeah, look at that. And then the final thing is the mix. Because as we talked about, if you’ve got products you sell at 60% margin and products sell 20, the mix of what you’re selling, you need to understand it, often the mix can completely mess up the margin, an example where services have high margin and products has low. Like in construction, labor can be higher margin, product material can be lower when you get a different mix. And the final thing is that just

Brad Giles  24:12

on that previous point that comes back to waterfall graphs, one of those second things, I think that we said there, so we want to analyze what are all of our products and services per gross margin over multiple period of time. So you could go back three quarters or three years and you could say this was our most profitable customer or product or service, and all the way down from the most to the least and understanding, really understanding what is going on there. And then what are the drivers behind that?

Kevin Lawrence  24:42

Exactly, and it helps you to see because basically you have to get underneath and see what’s actually going on. And finally in this accounting, just dig in and spend some time with the accounting team. I love working with the accounting teams. They always have a good sense of this. The good ones know they know what’s going on. They can get you the data. They’re actually not biased about it because they don’t have a horse in the race. They didn’t do the work. Yeah. Yeah. So the idea here is that there’s lots of opportunities, you just have to spend the time and dig in, the answers are there. And whether it’s operations, or pricing, or the markets that you’re chasing, there’s always ways to find and enhance it. But like a lot of things, if you leave it on its own idling for too long, it will degrade easily. It easily degrades without a lot of focus on it and strategy to help pump it up

Brad Giles  25:35

into a so my gross margin is dropping, what should I do? You should take action, you should analyze like that’s the that’s the quick and dirty, don’t let it keep going. Because it’s a very, very expensive thing to have happen. So analyze look through things look for, I guess we’ve been through it all, but look for all of the bits through sales, discounting operations, and the mix and then take action and fire bullets before cannonballs as we would always say, do small tests but take action. So there’s a couple of episodes related to this episode 148, the previous episode to this one, we need to increase in pricing, but the sales team is resisting interesting chats there. And then quite a long time ago, Episode 21 Gross Margin understanding the most important number in your business two episodes of relevance there. Well, thanks for listening. This has been the growth whispers Podcast. I’m Brandon, my co host with the Canadian accent here is Kevin in Vancouver, Canada. Of course, please be sure to check us out on youtube if you’re interested in our smiling faces. And please don’t forget to subscribe. Every time people subscribe and rate us we actually see our stats rise so it means the world to us if you could rate the show. Give us a five star we would love that in your app of choice. And then of course you can find Kevin and his very interesting newsletter weekly newsletter at Lawrenceandco.com and myself bread you can find at evolutionpartners.com There are you with our newsletter. I hope you’ve enjoyed the episode. Hope you got some practical advice there and do have a good week. Look forward to chatting to you again next week. Take care