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Know Your Margins! - Sep 15, 2008

Posted by: Jane Johnson in Articles

Do you know what your margins are? If you search long enough, you will find several different definitions for "margin" - but they should all have roughly the same meaning. Margin is the ratio of gross profit to gross revenue for the products and services you sell. Said another way: gross profit is the amount of money you have left after production to cover operating expenses and net profit. Thus, gross profit is a measure of a company's efficiency in turning raw materials into income. Those raw materials may be people and/or physical materials. For retailers, gross profit measures their markup over wholesale.

Gross Revenue - Direct Costs = Gross Profit

Margin = Gross Profit/Gross Revenue

All companies need to be concerned with their margins. It may sound simple, yet many companies do not know how to calculate margin and don't track it on a regular basis. Why is it important? If your margins aren't high enough to cover operating expenses, you are losing money and you will need to raise your selling prices or cut your direct costs to increase your margins sufficiently to achieve a net profit.

You may say that raising your prices is not possible because you are in a competitive situation. Are you sure? You need to review your pricing strategy often and determine if you want to be the low-cost provider, the most-expensive provider or somewhere in the middle of the pack. You need to try to predict your customers' behavior with each scenario. Will your existing customers switch providers if you raise your prices or is it too much trouble for them to do so? What new customers might you attract if your raise your prices? Are they better and more valuable customers? Will they spend more with you?

All companies should strive to cut their direct costs and improve their margins on a continuous basis. Here are just a few ideas:

Negotiate better contracts with your suppliers...all of them!
Cut your shipping costs...these are often huge expenses
Substitute parts that cost less as long as you can maintain quality
Determine if it is cheaper for you to outsource some or all of your production...should you use subcontractors?
Are there ways to reduce the amount of scrap or supplies used during the manufacturing process?

And don't forget to:

Carefully build incentive compensation into everyone's pay...you will pay more for high performance/production, but you will make higher margins if you do this well
Pay your sales commissions based on margins, NOT gross revenue. Give the salespeople incentive to sell at full price and avoid discounting!
Ask your employees for ideas...they are closest to the process

If you don't know what your margins should be, do a little research on your industry, see what your competitors are reporting and set a goal that beats the competition! It will make a big difference to your bottom line!