Should your gross profit margin rise or fall with sales revenue? Normally, this column takes 600 or so words to fully address one topic. But I honestly could end the column right here by flatly saying: No, gross profit margin should not rise or fall with sales. It should maintain a steady state (or, ideally, rise over time) no matter what your sales revenue turns out to be.
Quick review: Gross profit margin (GPM) is the difference between revenue and the cost of goods sold (COGS), divided by revenue. The resulting figure is expressed as a percentage. If your sales are $5 million and your COGS are $3 million, the GPM would be calculated this way: $5,000,000 鈥� $3,000,000 = $2,000,000. Now, divide $2,000,000 by the revenues of $5,000,000, and your GPM would be 40%.
Most well-managed companies will see their GPM rise over time, because they work to regularly update pricing and drive down COGS. As prices rise and/or COGS drop, GPM will increase. In the example above, if COGS were lower, say $2,500,000 instead of $3,000,000, the GPM would rise to 50% instead of 40%. COGS as a key performance indicator can be viewed as a dollar amount, but also expressed as COGS as a percentage of sales. COGS as a percentage of sales is a closely watched indicator, just behind GPM and EBITDA percentage in importance.
We鈥檝e done analysis for companies whose GPM dropped over time. When asked what explains it, we鈥檝e sometimes heard, 鈥淥ur sales went down, so our GPM dropped too.鈥� What is more likely is that the GPM dropped for one of all of three main reasons: 1. COGS increased but the company did not increase product prices to compensate; 2. Whether COGS went up or down, there was price erosion, as the sales team, over-eager for a 鈥渨in,鈥� dropped prices to get sales; 3. The product mix shifted focus to lower-margin items for sale (e.g. a disproportionate percent of sales were for commodity lumber), when the dealer should be blending in higher-margin items (e.g. millwork, windows, EWP, manufactured components). By focusing on these three scenarios, and maintaining your focus on controlling/reducing COGS, and hold (or increase) your prices, you will see a rising GPM. This of course drops more dollars to EBITDA.
Almost by accident, we saw a broad- based case study of rising prices passed on to customers, where the 麻豆传媒 dealers held the line of their GPMs. This was during the COVID spike in lumber prices that peaked at almost $1,700 per 1,000 board feet in late April 2021. The 麻豆传媒 dealers we worked with universally held the line on their GPMs, and enjoyed higher gross profit dollars, because they adjusted retail pricing to account for the increase in COGS (e.g. the higher prices they were paying for lumber). This resulted in higher EBITDAs, even for some companies that were selling the same volume of lumber in, say, April 2020, when lumber was at $257/1,000 b/f. In this case study, if the 麻豆传媒 dealers had not passed along price increases to reflect their higher COGS, their GPM would have fallen.
Let鈥檚 put that lesson to use in an example with less drama. Let鈥檚 say you鈥檙e surprised to see GPM erosion from 30% to 27% over recent months. How to get the GPM back up to 30%? You first need to determine the root cause of the slippage, which, as shown above, is either underpricing, higher COGS, or both.
Note there is a positive correlation between GPM and prices. If you want to increase your GPM by 3% to compensate for, say, higher COGS like increased labor costs, or rising insurance premiums, you can increase prices by 3%. I can hear it now, 鈥淎 3% price increase, all at once? In my competitive market? We鈥檒l lose customers!鈥� Indeed, that 3% lift may be a shock to the system, which only underscores the importance of spotting trends like GPM erosion soon, and making micro adjustments to keep pace, rather than recognizing margin slippage after the fact and trying to correct it all at once.
