Turn ambition into achievement

Venturn Understanding your gross margins.

This is an area of much debate and there are different schools of thought that can be grouped into; people who run businesses, and accountants. Understanding your Gross Margins is essential in running an effective business. To not understand them, often leads to financial ruin.

  • Understand every aspect of your gross margins; they are after all your only source of profit.
  • Challenge everything; do not accept any soft answers. Make sure that you understand the information in front of you. If you not sure what your reading, it is up to you to ask questions and find out.
  • If you don't understand what's being presented to you in your management accounts, ask the questions and ask for all the supporting information. It's far too risky to not understand your Gross Margins. If there's an error anywhere in your management accounts, it's likely to be buried in your cost of sales and work-in-progress figures so the probability of finding it is increased dramatically by understand this area.
  • Gross Margins are used to determine what you charge your customers. It therefore stands to reason that these figures need to be accurate and that you understand them. If you get it wrong, you are either charging your customer too much and therefore risk losing business, or you are not charging them enough and therefore risk losing the business.
  • Personally speaking, I don't like to see any form of overhead recovery used in your cost of sales. These are developed to apportion overheads in arbitrary ways and the formulae only work if you are on target and on budget. This can leads to over recovery or under recovery of overheads that quite simply, makes your management accounts too complex to understand. I have many examples of how businesses have made wrong decisions based on complex overhead recoveries misleading the management team.
  • Make sure that the definition of Gross Margins is the same in all parts of the business. This sounds surprisingly simple, but in my experience, most businesses get this wrong. Gross Margins used by the sales team for pricing, need to relate to the Gross Margins generated by your operations, which are usually your actual margins. The sales and operations Gross Margins again should be the same as those used by your finance team. I could write chapters on how this isn't followed and the problems that it causes. If in doubt, get your team together and find out.
  • Gross Margins are used to determine the efficiency of parts of your business and in particular, your hourly rates are used to generate your Gross Margins. Again, this can become complex as your hourly rates can often be an attempt to apportion and recover overheads. In my view, your hourly rates should include direct pay, pension, and national insurance only. Any effective working, absence and sickness and all other paid time that doesn't generate profit should be classed as overheads and dead costs. By treating them this way, you will focus on reducing them.
  • Finally, your business and product strategy are often determined from your perceived view of your Margins. Again, it therefore stands to reason that you make these critical decisions based on good information. If in doubt, say "show me" and find out for yourself.

Further reading

Stephen Moon, Venturn Ltd. April 2010

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