Should margin be the main consideration?
Margin might not be the key consideration in profit
A discussion in a previous column focused on the concern for declining margins. While we thoroughly examined the challenge from the perspective of a sales representative and the dealers they call on, we now offer consideration that the challenge is in the word itself; margin is not the solution but may be the problem.
Let’s take an example item and have a gross margin of 40%. Just to make sure we are all using the same math, the gross margin is calculated as taking the selling price, subtracting the cost, taking the resulting number and dividing that by the selling price.
This item sells for $10 and costs $6.00. With that gross profit of $4.00, and a gross margin of 40%, our dealer sells 50 of this item over the course of a year which produces $200 gross profit dollars.
The margin problem is that too often we look at too many items with the same formula in mind. This person who has the job of being the buyer is shirking their job of being the seller. After all, an old adage of business is that you make some of your money by buying and some of your money by selling.
Here is an example of how the buying and selling can work.
A second item has a cost of $1800 and is being sold for $200. The gross margin is a mere 10%. The dealer sells one of this item in the same year and has $200 gross profit dollars.
There is a third item with a cost of eighty cents and sold for one dollar. The resulting gross margin is better than the last item at 20%. Selling 800 of this item during the year produces a gross profit that matches the previous two items - $200.
What is the result? To the person who is paying the bills for this dealer, it is the same $200; it is just earned three different ways. But when it comes to paying bills, it is the same $200.
Was the buyer wrong in any or all of these products? Let’s look at each of the three. The first one with the gross margin of 40% was our example of how too many buyers make decisions. They take the cost and then apply a multiplier factor to determine the selling price. We are not arguing for or against this methodology; just acknowledging how it is frequently done.
The second item with the 10% margin was added because of an effort to solve a frequent problem; good, better, best. Or it is low, medium, high. Sometimes a customer makes a decision with a ‘give me a one in the middle’. Our $2000 item was added in an effort to move the customer’s ‘medium price point’ up a few dollars. If the previously most expensive item was $1600 and with this item it is now $2000 the average sale can increase. We refer to this item as providing ‘dollar contribution’.
The third item with the 20% margin gets the dealer to $200 by a different manner; sales volume. It the dealer is buying this item 50 at a time, then they are definitely having good inventory turn.
Take a look at all three. One gets the dealer to profit by way of margin; a second by dollar contribution and a third by inventory turn. It is the answer to what was the initial observation – margin by itself can actually be a problem.