The owner of a small bakery in Northern California has created the very best gluten-free baked goods anywhere. She is a true artisan baker who is extremely focused and—since her passion and expertise is baking—she outsourced the accounting function.
In 2008, when I first met her, she informed me that her No. 1 and No. 2 selling items were these superbly gooey cinnamon rolls (which she now sends me each year for my birthday!). Soon we would discover that these same delicious products would prove to be the driver of her major business issues. While my client was very aware of her issue with profitability because she'd been delegating the accounting function, it wasn't immediately clear what was driving the losses.
I asked to review her key financial documents:
- Income Statement
- Balance Sheet
- Aging Accounts Receivable
- Aging Accounts Payable
This review is always the first step in a client assessment. You might think that the net income line of the income statement would be the first place to look, but that's not where I started.
Any business can be profitable one month, and not profitable the next or perhaps across several months. It might be as simple as attending a trade show with high expenses during one month, or a multi-month effect of seasonality, such as the summer as a low season for baking. Profitability can swing widely, and needs to be viewed over several months minimally to truly measure its contribution to the health of a business.
My eyes went higher up the income statement, and I didn't just look at one line item; rather, I focused on two to make a calculation. I divided the net profit (revenue - cost of goods sold) by the gross revenue to obtain the gross margin percentage.
So what's a gross margin percentage?
Beyond its calculation, it's an indicator of a CEO's ability to price products correctly (or adequately), to manage key product and ingredient expenses, and to give the business its best chance at achieving desired operating results.
The result? About 25% margin: no yeast in that flat result. The quick observation: With that level of average gross margin, the bakery would never have a chance to become profitable ... ever.
What was the issue?
Without a perfect knowledge of the gross margin, the pricing cannot be set optimally and you can't determine the money-makers vs. the money-losers.
The owner immediately took back the leadership and focused on calculating the cost of each one of her products, and the findings were astounding. Her cinnamon rolls were among her lowest margin items of all! So she had to raise the prices right away. Other items were jettisoned.
She became instantly profitable...really! Soon after she turned her first ever profit for the year.
Good gross margin on its own will not deliver great operating results, but a bad gross margin will drive you out of business ... quickly.
A dozen tips for managing your gross margin
What can you learn from the artisan baker to help you cook up a great result? Here are a dozen hot tips for managing your gross margin.
- Know what it is and how to calculate it. If someone else is handling your accounting, insure that the inputs and analyses are accurate.
- Track it. It needs to be one of the key metrics you review minimally at least every month, and even more frequently if you (are likely to) experience unexpected increases in COGS.
- Get into the detail of your COGS. Know what your costs are for each and every ingredient.
- Calculate the COGS for each of your products. Especially if you have many items, you must know and rank your products in order of their gross margin contribution.
- If a product's gross margin is too small, try to raise the price or lower the COGS (especially if it is a significant part of your sales).
- If you cannot do either, consider getting rid of the product. Low gross margin products can wind up being money losing, and you don't need it.
- Project out your COGS for each product for at least one year. Talk to your suppliers to understand how pricing might evolve in the near and longer terms.
- Understand the risks associated with the COGS. Does your product formulation contain an ingredient with volatile pricing (such as cocoa or oil)?
- Consider "locking in" your COGS (forward contracts, prepayments or volume purchases with your suppliers).
- Be fully engaged with each of your suppliers. Insure that they are paid on time and keep up constant contact; you must have their trust and their perspective on the future.
- Teach your key internal staff about the importance of the metric and understand how each person (your purchasing manager, for example) may affect it.
- If there is a material/major higher change in your COGS at any one time, immediately calculate the effect and take immediate action to reduce expenses or drive topline revenue.
- (Hey, it's a baker's dozen). If you have a good gross margin and know it is under control for the foreseeable future, feel more confident about approaching an equity or debt financier. Highlight it in any conversation or document to demonstrate your good management skills.
If you follow these tips, the benefits are phenomenal:
- You've achieved a more sophisticated understanding of your business and investors will recognize that. Gross margin is something investors always look at.
- You have the very best chance, aside from the effect of one-off expenses, of achieving consistent results (not necessarily profitability).
- Even more important, you will know at any one time if you can afford a particular decision.
So, as part of your monthly review of your results, be committed to tracking your gross margin and managing it actively ... it just might be the best way to bring in more bread.