Successful high-growth businesses know that a key contributor to a thriving business is a true understanding of the Cost of Goods Sold and Gross Margin. Here are a few points you should know:
- What is included in Cost of Goods Sold and Gross Margin?
Cost of Goods Sold (“COGS”) represents the direct costs of producing the products and services that you sell during a given year or period. Gross Margin is the profit that comes from your Net Sales less your COGS. Gross Margin can be increased by increasing Net Sales (through price increases, lower discounts, etc.) or by decreasing COGS. Or both.
The basic formula for COGS is:
Opening Inventory + Purchases of Direct Materials + Labor for the Period
– Closing Inventory
It is important to note that in determining COGS there are many related considerations, such as the method used to cost inventory (last-in-first-out, first-in-first-out, etc.) and the extent to which direct overheads are included with direct materials and direct labor.
- What can I do to better manage COGS?
Companies have many levers available to reduce COGS and improve Gross Margin. Some methods that can have the greatest impact:
- An accurate “Bill of Materials” – having a solid and true understanding of the Direct Materials and Direct Labor that goes into each type of product that is made, which allows you to find ways to reduce waste, rework, etc.
- Negotiating better pricing or discounts on inputs into each product
- Considering “make vs. buy” options for certain production components
- Ensuring a resilient supply chain
- Evaluating and improving manufacturing efficiency
- How can better understanding my costs help me set competitive pricing?
Companies often claim that they simply price their products at a level the market will bear, or base their prices at a level similar to competitive products. While this sounds like a plausible approach there is another key factor that must be considered: How does your cost structure compare to that of your competitors?
- If it is lower, you may actually be able to price your product at a lower price and take market share away from your competitor. Or simply enjoy the higher gross profit margin on those products.
- If you are not making an acceptable gross margin on certain products at the current price, perhaps you need to re-engineer the way that those products are made so you can improve margins, or exit the unprofitable product line altogether.
- What are the “hidden costs” of inventory that I should consider?
Unlike a good wine, inventory generally does not get better with age! Careful inventory management can have a sizable impact on COGS and Gross Margin in a number of ways:
- Well-managed inventory can ensure that production continues to run smoothly and orders are shipped to customers on time, ensuring good customer satisfaction and the revenue that comes from completed shipments.
- Inventory has carrying costs. Most companies have a line of credit or other financing source that they use to fund the carrying of inventory. But even with low interest rates, carrying costs due to interest can be significant.
- Inventory takes up space. Poorly managed inventory often results in warehouse space being allocated to damaged, obsolete or slow-moving inventory. This warehouse space can be expensive (consider the cost of HVAC, staff, insurance, etc.). Usually, the continued presence of damaged, obsolete or slow-moving inventory is a sign of inaccurate Bill of Materials, managers who are “hoarders” (“Because we may need it someday!”), or systems that simply cannot accurately track key areas, such as what you have, when you last used it and where it is. This limits the ability to dispose of and write-off what is no longer needed or likely to be used.
Now is a good time to carefully review your inventory. Identify slow moving items that could be discounted to accelerate sales, and dispose of items that are obsolete or damaged.
- How do I structure my operations to deliver my products and services in a more efficient manner?
In today’s “instant” world, focusing on efficient manufacturing and prompt delivery of products and services is essential. Examine the options of “make vs. buy” for certain components – what production elements should be done in-house vs. those that can be outsourced to a third party. You might also consider taking full advantage of digital technology, including websites, remote devices, and other means to speed order entry and tracking.
Successful companies continually evaluate their business model and improve their performance through monitoring ratios and metrics such as:
- Order to delivery cycle time
- Unit production volumes
- Returns and allowances volumes
- Customer satisfaction surveys and Net Promoter Scores
- Inventory turns
- Accounts receivable collection period – days of sales, etc.
- Employee metrics such as overtime, turnover, revenue per employee, etc.
As you strive to focus on efficiently managing your business, think about the unique metrics that you should be monitoring,
- Supply chain
A reliable supply chain is an essential part of any successful business. In challenging times like this, good communications and intelligence through all aspects of your supply chain are particularly important.
Do you have an efficient way of communicating production and shipment needs with all parts of your supply chain so they can anticipate and respond to your needs in a timely manner? Are there “weak links” in your supply chain? For example, suppliers that are having financial difficulties or fail to properly staff their operations? If so, it is time to source alternative suppliers, perhaps in a different geography or who are financially stronger, in order to maintain the resilience of your supply chain. After all, if you don’t have product then you will not have sales.
Upcoming articles in this series will look at Strategic Business Planning topics such as identifying and sourcing appropriate financing for your business.