Managing profit margins is a key component to selling smart. That, in turn, requires you to understand the financial structure of your business. Some margins you might offer are too low to sustain business, while other margins are so high you'll never make a sale. Like Goldilocks and the Three Bears, you want margins to be just right.
When is the margin too high? It depends on the product category and customer demand. I've seen markets where you can generate in excess of 50% gross margin for installed interior doors and trim. I've also seen markets struggle with 16% for this same product. There is no magic pill that will reveal all to you–this is trial-and-error time. If you miss a sale because of a too-high margin, aim lower and try again.
It's a lot easier to figure out when your margins are too low. These minimum margins shouldn't be considered a starting point for pricing, but rather as the hard deck you cannot go under when dealing with a customer.
Let's explore why it's paramount to maintain a minimum margin. We'll start with a refresher course on three key figures:
Net Sales This is just what it sounds like. A net sale is the total of the contract or quote price as accepted by the customer.
Cost of Goods Sold (COGS) represents the accumulated cost of all goods and services related to product distribution. This item may, depending on how your P&L is set up, also include distribution costs for those goods.
Gross Margin Net sales costs minus cost of goods sold yields gross margin dollars.
If you are involved in installed sales, your COGS will also include related labor for the project. Likewise, factors such as rebates, returns, and adjustments will play a role in your adjusted gross margin.
In all but the rarest of cases, if your gross margin is below 20%, you will not be able to cover related costs and you will result in a loss rather than a profit at the end of the accounting period. Why? Let's say you have a gross margin of 19%. Take away three points for overall corporate returns and adjustments and one point for company-wide bad debt, and then add one point for rebates. The result is 19 percentage points minus three points, giving you an adjusted gross margin of 16%.
Now take that adjusted gross margin of 16 points and subtract 2 points for sales commissions and 3 to 5 points for distribution expenses. That yields a variable margin of 9% to 11%.
There's more. Assuming a variable margin of 9 points, now remove 10 points for your company's fixed costs and 3 points for various other costs. That yields a true net profit/loss of negative 4%.
Clearly, if you want to turn a net profit, the gross margin needs to be higher than 19%. Simply selling more at a lower margin won't do you any good, because doing so will increase all your expense categories, such as distribution and accounts receivable costs. On the other hand, there isn't any associated selling or operational cost with raising gross margin.
What to do? Carefully work within the guidelines provided by your company and ensure that when you submit a quote, you consider all of the costs, both variable and fixed, to protect the organization's future. Selling smart equates to knowing what's best for your business–not simply how to sell lumber.