An Epicor White Paper

Expanding YourGross Margin in Distribution

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Table of Contents Introduction 1

Understanding Gross Margin 2

Financial Factors that Affect Distributors 2

Gross Margin Concepts 3

Key Ratios for Improving Gross Margin 4

Rewriting the Net Profit Equation 5

Increasing Sales 6

Lowering the Cost of Goods Sold 7

The Importance of Action Lists 8

Advice From Veteran Distributors 8

About the Author - Bill McCleave 9

About Epicor 10

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Introduction The recent recession has forced distributors and manufactures to pay closer attention to the bottom line and to the financial factors that contribute to profitability. Gross margin is a popular measure of a company’s financial condition; but using gross margin without understanding how it affects profitability and business strategy can be misleading. An understanding of the relationship between the financial components of gross margin is essential for formulating sales and product strategies

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Understanding Gross Margin “I’ve worked with managers all over the world, and while knowledge about your business and the market is important,” McCleave says. “But what you do with that knowledge helps enable success.” Companies become successful and differentiate themselves from their competitors by applying their unique experience and market knowledge to the formulation of strategy and for prioritizing tasks.

Financial Factors that Affect Distributors

Most distributors and manufacturers pay close attention to three financial measurements: the income statement, the balance sheet, and cash. Of the three, most companies worry most about cash, because a cash balance is required for daily business operations.

Even so, many companies consider return on investment (ROI) to be an important measure of business success. McCleave defines ROI as “the result of dividing the Capability Diamond for Market Profitability by the balance sheet” (Figure 1). The balance sheet provides businesses with a look at three important business factors: cash on hand, inventory, and credit. The recent recession has forced companies to become more adept at managing debt, but there are other business factors that can affect the company’s financial condition in a positive way, such as:

More effective sales and marketing,

More effective procurement practices,

Lowering the cost of goods sold (COGS),

Improvement in business processes, such as better management of inventory, and

Increased productivity of people in the organization

Figure 1: Financial Factors that Affect Distributors

Source: W.R.McCleave © 2012

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Gross Margin Concepts

To better understand the concept of gross margin, Figure 2 shows an example of a distributor income statement. This particular distributor had sales of $40 million, with COGS of $34 million, resulting in a gross margin of $6 million. The company spent some money on operating expenses and wound up with a profit of $200,000. While these results are better than no profit or a loss, the $200,000 profit is only one-half percent of sales, which is very small return for hard work in a difficult economy.

Of course, the distributor survived one of the worst recessions in U.S. history and still managed to achieve some degree of profitability. Many companies survived the recession by lowering operating expenses, but this is not a good long-term strategy for business growth as economic conditions improve.

Figure 2: Distributor Financial Statement

Source: W.R.McCleave © 2012

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Key Ratios for Improving Gross Margin

The equation for calculation of gross margin is: = −

Thus, the only ways to increase the gross margin are to raise sales or lower COGS. However, there are two other formulas, expressed as ratios, which can be used to assess the financial health of a distributor (see Table 1).

The first ratio is called the Cost of Goods Percentage, which is found by the following formula: =

Using the numbers from the sample distributor, the number calculated for the Cost of Goods Percentage is 85 percent. This means that for every dollar of sales, 85 percent is paid to suppliers for the finished goods that the distributor sells. The Cost of Goods Percentage is also known as the payout ratio; a lower payout ratio indicates a better balance between sales and the cost of goods sold.

The second useful ratio is the Gross Margin Percentage, calculated by the formula: =

Using the numbers from the sample distributor, the Gross Margin Percentage is 15 percent. McCleave calls this the work with ratio. Higher work with ratios indicate that there is more money available to the business to fund operations.

Table 1: Key Ratios

Cost of Goods Percentage Gross Margin Percentage

Cost of Goods Sold --------------------------

Sales

$34 million -------------

$40 million

85%

Payout Ratio

Gross Margin $ --------------------------

Sales

$6 million -------------

$40 million

15%

Work With Ratio

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Rewriting the Net Profit Equation

The traditional way of calculating net profit was shown earlier. McCleave prefers to write the net profit equation horizontally rather than vertically, because this makes it easier to see how the parts of the equation interact with each other (Figure 3). There are only four ways to raise a company’s net profit:

Increase sales

Lower cost of goods sold

Lower expenses

Increase “other income” on the balance sheet

Figure 3: Net Profit Equation (Rewritten)

Source: W.R. McCleave © 2012

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Increasing Sales

Improving sales numbers is one of the methods of raising net profits for the company. Some of the actions a company could take to increase net profit include:

Increase the selling price of the goods the company sells

Increase the number of units sold to customers

Increase the selling price and the number of units sold

McCleave cautions, “You might consider both lowering the selling price and increasing the number of units sold, but you need to be very careful with that strategy.”

There are a limited number of ways to increase sales for existing customers. A distributor could change prices on products or services, increase the number of units sold, or a try a combination of both actions. The company could also look for new customers in existing markets or for opportunities in new markets. Figure 4 summarizes the various combinations for increasing sales. The various combinations for increasing sales.

Figure 4: Possible Actions to Increase Sales

Source: W.R. McCleave © 2012

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Lowering the Cost of Goods Sold

In addition to improving sales, distributors can look for ways to reduce the cost of goods sold. McCleave suggests that the best course of action is to reduce its “landed cost,” which is the total cost of a product once it has arrived at the company. Some ways to reduce landed costs include:

Lower the purchase price of goods

Lower freight, handling, and other costs associated with obtaining products

Reduce inventory losses, which are generally charged against the value of the company’s inventory

The range of options available for lowering cost of goods sold is summarized in Figure 5. McCleave notes, “We may not necessarily want to lower the total cost of goods sold, because as sales rise, the total cost of goods will also rise, unless we lower the overall cost of goods as a percentage of sales.”

Figure 5: Ways to Lower Cost of Goods Sold

Source: W.R. McCleave © 2012

As with the discussion about increasing sales, a company has several alternative ways to reduce the cost of goods sold, whether on current products and services or on new products or services that the company is considering:

Switch from a current product to a substitute

Reduce freight costs by switching to a new product or using a supplier that is closer than the current one

Find products for which freight is included in the price

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The Importance of Action Lists

McCleave challenges his consulting clients to develop an action list for each of the four target areas: increasing sales, lowering cost of goods sold, lowering expenses, and increasing other income. Tasks on the action lists need to be as specific as possible, so that corporate actions are directed at reaching the desired goal. For example, if the action list concerns increasing sales, one action might be to install a CRM system to help the company better manage sales. The best results will be achieved if there is an action list for each target, but at a minimum there should be an action list for sales and another for cost of goods sold. McCleave cautions, “One thing is certain: change won’t happen if you don’t start with a clear list of actionable items.”

Advice From Veteran Distributors McCleave’s experience with hundreds of distributors leads him to make some recommendations:

As a result of the economic conditions of the past few years, many companies have pared costs and improved processes to make them more efficient, but as the economy improves it’s important to maintain the focus on controlling costs

Investments in productivity and process improvements should continue, as these actions help to keep expenses from increasing

Increasing sales has the greatest impact on increasing gross margin and is easier for most companies to achieve than lowering the cost of goods sold. Salespeople play a key role in helping the company to grow, but it is important to monitor their efforts and make sure that they are being as effective as they can be in selling

A renewed focus on purchasing will ensure that any money saved on goods will help to lower the overall cost of goods, which also increases gross margin

As the post-recession business climate improves, companies should be prepared for the increased cash necessary to fund operations and inventory as business rebounds

Understand the business strategies and tactics of key competitors, especially if they’ve only recently moved into distribution; these comparisons will help to mold business strategy and make the company more competitive in an expanding market

Companies tend to hold on to traditional methods, but today’s business climate demands new and innovative business methods. Process improvement and continued investment in technology to manage the business is one of the keys to long-term growth and success.

Gross margin is only one of the measures of a financially healthy company, but it is an important one because of the business factors that comprise it. An increased understanding of the underlying factors that make up gross margin, coupled with the techniques presented in this paper, will enable companies to increase their net profit and maximize their return on investment.

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About the Author - Bill McCleave

Bill McCleave is the president of W. R. McCleave & Associates, a consulting firm based in Cornelius, N.C., that specializes in relationship management for industrial distributors, manufacturers, and their customers. McCleave has more than 25 years’ experience in the industry, and is a nationally recognized speaker, trainer, and expert on integrated supply.

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Contact us for more information on Epicor Products and Services

About Epicor Epicor Software Corporation is a global leader delivering business software solutions to the manufacturing, distribution, retail, and service industries. With more than 40 years of experience, Epicor has more than 20,000 customers in over 150 countries. Epicor solutions enable companies to drive increased efficiency and improve profitability. With a history of innovation, industry expertise, and passion for excellence, Epicor inspires customers to build lasting competitive advantage. Epicor provides the single point of accountability that local, regional, and global businesses demand. For more information, visit www.epicor.com.

This document and its contents, including the viewpoints, dates and functional content expressed herein are for informational purposes only and are believed to be accurate as of its date of publication, November, 2012. However, the contents are subject to change without notice and Epicor Software Corporation makes no guarantee, representations or warranties with regard to the enclosed information and specifically disclaims, to the full extent of the law, any applicable implied warranties, such as fitness for a particular purpose, merchantability, satisfactory quality or reasonable skill and care. Epicor, Epicor Business Inspired and the Epicor logo are trademarks of Epicor Software Corporation, registered in the United States and certain other countries. All other trademarks mentioned are the property of their respective owners. Copyright © 2012 Epicor Software Corporation. All rights reserved.

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