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How Gross is my Margin?

Guest post by: Stan Prokop

Article Overview: The article provides insight into the value for business owners and financial managers to understand gross margin and how it affects overall profits and business risk .

How Gross is my Margin?

All successful business owners and financial managers want to stay on top of profit, as it is essential to the firms long term success and growth. We all know the basics of profit - i.e. it's what left after expenses are paid and ultimately it's a measure of how successful we are in operating our company efficiently. Over time a company that has less and less profit will be unable to pay bills and buy materials. Also both lenders and investors will of course view the business as problematic, leading to an outflow of capital. And of course those profits allow us to grow our businesses to even new heights of success.

Let's take a look at some basic ways that business can measure profits, from the view point of are they enough, and how can we improve and control them.

A great way to start is for a business owner to understand and be able to address 'gross margins '. It is simply the gross profit deiced by net sales, and we then multiply by 100 to express the number as a percentage. What does this number tell us? It allows us to see the difference between our sales and the cost of those sales. (Keep in mind that doesn't reflect our administrative expenses also) A higher gross margin is good, as it allows bills to be paid and leave a reasonable profit for the owner. Business owners from small start ups to major corporations watch the gross margin very carefully.

How does the business owner address and interpret gross margin - Essentially it reveals that material costs are too high or sales are too low. Steps must be taken to fix both or either!

We need to note that that gross margins are different in every industry. In the grocery business margins are very low, but sales and turnover are very high. Products are essentially a commodity in the grocery industry. Don't forget also, using our grocery business as an example, that there are a large number of products in that store. Each product delivers a different gross margin to the business owner, some more, some less. Therefore we can glean from this that we must watch the mix of products and the margin they deliver back to our company.

Another takeaway from our gross margin analysis is that overall risk to the business increases when we are in a low margin business - there is simply little room to move when things go wrong! Business owners have the option, and many do, of maintaining their margins by a pricing strategy - let's say a business owner has a budget goal of achieving a 25% gross margin. As his material costs and inventory costs change he simply re prices his product to achieve that desired margin.

In summary when managers understand their gross margin they can more effectively buy goods and price them correctly. That's important.

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Article Tags: business risk, gross margins, insight, profit financial managers



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"Costco refuses to be undersold and thinks so long term that the company will not even remotely degrade the value it gives customers, even if it would fuel a healthy increase in margins and earnings and very few customers would notice," says Ken Charles Feinberg, a co-manager of the Davis New York Venture Fund (NYVTX) and Selected American Shares (SLADX), both run by Davis Selected Advisors. "That's how a great management builds a great business franchise that's built to last." The Davis funds are Costco's largest shareholder, with a 12% stake. Feinberg says that Costco's effective valuation is lower than its stated price-earnings ratio because of the company's conservative approach to depreciation. He recently calculated that Costco trades for about 16 times his projection of calendar "owner earnings." This profit measure adds to operating earnings depreciation expense in excess of what is needed to maintain the existing store base. Feinberg believes Costco is a "compelling bargain" for long-term investors. Sinegal doesn't talk much to Wall Street and wasn't available to speak with Barron's. Even at 70, he maintains a grueling schedule. He aims to visit each Costco store twice a year and is about 70% successful in that goal, Galanti says. This means he's on the road 40 to 45 weeks a year. Costco executives jokingly refer to Sinegal's weekly travels as a "death march" because he usually begins each day at 7 a.m. and finishes at 10 p.m. Dressed in sneakers, khaki pants and Costco's now-$14.99 button-down shirts, Sinegal asks store managers what's selling, what's not and how Costco prices compare with the competition. He has no set plans to retire, although he has talked casually about holding the job for five more years. Because he hasn't set a retirement date, there is no heir apparent. But Costco has a strong group of managers who share Sinegal's passion and vision. Unlike most CEOs, Sinegal has no severance or golden parachute in his contract, which runs less than a page. He insists on one-year contracts, believing the Costco board should have the opportunity to evaluate him annually to determine if he's still up to the job. Sinegal's view is that the restrained terms of his contract send an important message to employees. In the view of Berkshire's Munger, one of Costco's great strengths is that its two founders, Sinegal and Brotman, are still active. Brotman, 64, focuses on real estate. "There is no better site acquisitor in the retailing industry," Munger says. "I'd like to see Jeff get more credit. He deserves it." Costco has chosen to focus on more affluent coastal markets; California alone is home to 30% of its stores. Finding sites for new outlets in densely populated areas is one of Brotman's specialties. The company features products that offer its members large cost savings over what they would pay at traditional retailers. The chain carries just 10% of the items in a typical supermarket, which might stock 40,000 products.The formula works. Costco sold 1.5 million TVs last year and has successfully built what it calls ancillary businesses such as prescription drugs and eyeglasses, filling 26 million prescriptions in 2006. Hungry Costco members bought 63 million hot-dog-and-soda combinations last year at in-store snack bars -- priced at only $1.50 and with free soda refills. The dogs are even kosher. Costco's customer-focused strategy is apparent in its 87% membership-renewal rate. The retailer allows returns on nearly all items at any time, with no questions asked; computers are the lone exception. It doesn't even need to see receipts. This liberal policy has proved costly in the past year because the company is seeing returns of an unusually large number of big-screen TVs. Analysts suspect that many members are taking advantage of the sharp drop in TV prices to return models bought in the past 12 months so they can buy new ones at lower cost. Costco said it is evaluating its TV-return policy but emphasizes that no change will be retroactive and that it still plans to maintain the industry's most generous return policy on electronics. Low turnover among employees Workers get a relatively good deal at Costco -- a point of emphasis for the company, which contends it's also a matter of good business. Despite fewer stores, Costco's sales are about 50% above those of Sam's Clubs, and sales per employee are about $500,000 a year versus $340,000 at the Wal-Mart unit, UBS' Currie calculates. Sinegal was asked in a recent Bloomberg TV interview about the company's health-care benefits. Costco provides health insurance to its 93,000 domestic employees and pays 90% of the cost, which runs about $6,000 annually per employee. Video: Behind the scenes at Costco "We're 100% committed to maintaining this program," Sinegal said. "It works for us, and our people count on it. We think they're entitled to that security." Costco has one of the lowest turnover rates in retailing. Among employees who have been with the company for at least a year, just 6% leave annually. That may be because store employees such as cashiers can earn more than $40,000 a year after only four years on the job. Costco shares aren't a bargain at current levels, but patient investors could be rewarded because the company is an industry leader with top-notch management, a loyal customer base and solid growth prospects in the U.S. and abroad. In Street-speak, Costco may be "under-earning," meaning its profit margins are lower than they need to be. Management is loath to tinker with a successful formula, but margins probably have only one way to go: up. In time, the shares are likely to follow. This article was reported and written by Andrew Bary for Barron's


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