One of the most critical components to predicting business success is the gross margin for your product line. Gross margin is the difference between the costs related to manufacturing the product and the net price at which you sell product to your customers. There are many accounting variations to determining gross margin for your products. For the purpose of this exercise, we prefer the following formula be used.
First determine your cost of goods (COGS). Factors that go into determining COGS:
- Ingredient costs
- Packaging costs
- Labor costs or co-packing fee
- Manufacturing overhead (portion of rent, insurance, utilities, etc.)
- Freight/storage costs to F.O.B. point
Then determine your net sales:
Less: Promotional discounts
Less: Cash discounts
Less: Returns, spoils, etc.
= Net sales
Then divide cost of goods by net sales and subtract the quotient from one to get your manufacturing gross margin percentage:
1 – (COGS) = Manufacturing gross margin percentage
What margins do I need to have a successful business model?
The answer to this question depends on several factors such as the product category in which you compete—how competitive it is, your overhead costs, product turns, etc. However, generally speaking, you need gross margin of 40-plus percent. To have a successful natural or specialty business, your business must generate a margin large enough to support overhead costs (rent, insurance, salaries, freight, R&D, etc.) and the marketing and selling expenses needed to build your brand.
A 40 percent margin is barely adequate to support the expenses involved in building your business. If your product is co-packed and you keep your office expenses minimal, you may be able to squeak by with a 30% to 35% margin, until volumes develop. A common fallacy among small manufacturers is, “My margin is only 20% to 25%, but my costs will come down as my volume increases.” They then build a business model around unrealistic scenarios with little room for error. Unless you are 100% certain that healthy, sustainable margins are within short-term reach, you really need to reconsider your position and face reality. An old truism is: “It is better to fail quickly than to fail slowly.”
This content is excerpted from the Natural Products Field Manual, Sixth Edition, The Sales Manager’s Handbook, written by Bob Burke and Rich McKelvey. To learn more about or purchase the Natural Products Field Manual, visit the Natural Products Consulting Institute website.