Why Does Gross Margin (Almost) Never Correlate to Profit?
•distribution management best practices •profit strategy •Wholesale Distribution Industry •business math for distribution •wholesale distribution basic mathFriday, August 8, 2014—This week, I got a great question from a colleague: "Why is there no correlation between gross margin and bottom-line profit?" This is the exact question every distribution executive and manager should be asking.
The reason there's no correlation is because Gross Margin accounts only for product cost, and has no accounting at all for expenses.
Because there's rarely been sophisticated cost modeling, most executives think instinctively of averages — a certain percentage of every sale will make its way to the bottom line. This is flat wrong, and the logic is what leads to mediocre profit performance in most companies.
In reality, each sale has its own expense or "cost-to-serve" envelope, and if that amount is greater than the gross profit from the sale, it actually adds a loss to the bottom line — no matter how high the gross margin. In typical wholesale / distribution companies, more than 60% of all the sales transactions will contribute only losses. This wipes out the stellar profits from the top 5%-10% of the business, leaving — at best — an average performance.
Second-tier companies — those that run at 3X-5X the profit rate of the average — use this knowledge to allocate their resources and prioritize their efforts on the 40% (really, the <10%) that make all the profit.
Understanding that most sales are not good for the company is the very basis of the secret strategies that the high-performers utilize to out-class the competition. Their competitors sit like the proverbial monkey with its hand in the nut jar, refusing to let go of all the nuts that make it impossible to pull its hand through the neck of the jar. They'll keep a death-grip on the money-losing business, while the high-performers are totally focused on serving accounts with low cost-to-serve. The most aggressive players also have policies that actually encourage the money losers to go to weaker competitors, further paralyzing the competitors' ability to identify and serve good accounts.
Because of whale-curve dynamics (ask me about this later), the most profitable accounts can, and do, generate up to five times the average profit rate, paradoxically at margins up to 5% lower than average, and are frequently in a lower revenue tier than the "biggest accounts". This is another secret that gives advantage to the top-performers — their weaker competitors are pretty much blind to the identity of the best accounts. (It's pretty easy to poach when nobody's watching the gate.)
For these reasons, we strongly encourage our clients to move beyond gross-margin management, and adopt metrics like NBC (Net Before Compensation) so they're not subject to the blind spots that have most companies driving along the ditch.
This sounds like heresy to many, but having spent the best part of a decade in the numbers, I've seen this over and over. (I have the privilege of hanging with a lot of the top-performers, and they know and use these techniques.)
For more information about Randy MacLean, visit: www.waypointanalytics.net
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