For most companies, the Gross Margin is one of the most important measures of business performance. In this blog, we are going to show you why it could be the most dangerous measure during these recessionary times.
How can that be? Surely all profit is good, so more is better, right? Well, as they say, it DEPENDS…
Take a distributor, dealer or a retailer selling two products, that happen to have identical gross margins.
One (let’s call it a Widget) is a well known brand that practically sells itself, virtually never gets returned, works just the way the customer expected and comes in a square box that stacks neatly up to six feet high.
The other (let’s call it a Sprocket) is new in to the market, often gets returned because the instructions suffered in the translation and frankly it isn’t that reliable anyway, and it comes in some fancy packaging that involves several see through plastic bubbles and can’t be stacked.
You’re probably ahead of me here, but which one actually makes the most profit for the retailer? The Widget, – but hang on they make the same gross margin! How can that be?
The concept that applies here is call the Contribution Margin and it takes into account all the ways a product affects the dealer or retailer’s operating costs. So the Sprocket makes a lower contribution margin because it incurs:
- a higher selling cost because it takes more time to sell as no-one’s heard of it before
- a higher product support cost because customers keep asking how to make it work
- a higher reverse logistics costs because it gets returned a lot
- a higher warehousing, shipping and display cost because it’s awkward to handle, takes up more room and space in the supply chain and in the store
In retail, these costs are called Direct Product Costs and they are deducted from the Gross Margin. In other channels they are recognised as Variable Costs. Either way the Contribution Profit is calculated taking these costs into account and the Contribution Margin (Contribution Profit divided by Sales Revenues) reveals the true picture.
Why is this so important in recessionary times?
The contribution margin is so called because it is about measuring the contribution to fixed costs. And in recessionary times, it is the fixed costs that cause the problems because the lower level of sales can’t generate enough profit contribution to pay for them all. (And being fixed, means that it usually takes quite a time before you can take action that will reduce these costs, which include Payroll, rent, depreciation etc).
If you were to focus only on gross margins, you might think it didn’t matter whether you sold Widgets or Sprockets, but the contribution margin tells you that you will make a muich bigger contribution to fixed costs if you sold more Widgets.
Obviously as long as a Sprocket makes a positive contribution (ie it has a contribution margin > 0) then it’s better to sell a Sprocket than nothing. But if you can influence the customer, you’d want them to buy a Widget instead of a Sprocket.
So what can I do if I work for a widget or sprocket vendor?
The easiest thing you can do to improvee the contribution margin is to improve the gross margin. This might mean offering higher discounts, greater rebates (in return for increased sales volumes).
After that the best thing to do is to help with the marketing costs in the form of funding or special allowances. These could be tied to performance such as putting the product on display, into special locations or including it in special promotions.
Alternatively, the funding can be directed into special programs that focus customers on your product (but if the dealer or retailer incurs increased costs that you simply reimburse, then contribution is not improved).
Finally you can bear some of the costs, such as the reverse logistics, product support which work very directly on contribution; or increase brand advertising and promotion to increase consumer demand which works on lowering the cost of selling.
Does this mean Contribution Margin is the best measure to use in recessionary times?
It’s certainly the best Return on Sales measure, or margin measure. In the next blog, we shall show the best overall measure, which is a specific type of Return on Capital measure..and as we know capital is in rather short supply just now.
Comments? Questions? We’ll try and help. If you want to go into these topics in more depth, check out Julian Dent’s book “Distribution Channels – Understanding and Managing Channels to Market”.