www.quantumprofitmanagement.com Quantum Profit Management
Cost-to-Serve Math: Why Gross Margin May Fool You Every Time

Bruce Merrifield, President — Merrifield Consulting

•WayPoint Analytics •profit strategy •management strategies •business math for distribution •cost-to-serve math •cost-to-serve in distribution

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Does your company have a "magic percentage" when it comes to sales? Do you assume that any sale with a gross margin higher than that percentage will automatically make money? If so, you've likely been fooling yourself.

In this video interview, Bruce Merrifield and Randy MacLean discuss cost-to-serve math. We explain why you can't rely solely on gross margin to determine profitability and illustrate this idea through examples that you can probably relate to in your wholesale distribution company.

Most wholesale distributors have a 3% operating profit. If your company has a 25% gross margin, then you might think that any sale with a gross margin over 22% will be profitable... but you'd be wrong!

There are no fixed, static numbers when it comes to a profitable gross margin because cost-to-serve is hugely variable. You could have a gross margin that's anywhere from 10 to 45% but your cost-to-serve can go from 0% to 300% or even 500%.

A 22% gross margin may work for a nominal sale, but what happens if you have a back-order? If you send 5 items today and 5 next week, you have 2 separate invoices, 2 separate deliveries, and you have to collect from the customer twice. It's no longer a 22% operating cost, it could be a 32% operating cost. Instead of making 3%, you're now losing 7%.

What happens if the sale is for a small amount of product, but there are 22 lines on the invoice and each line costs $14 to pick? On a $200 dollar sale, you're going to be way underwater because there's more logistical cost in that sale than allowed for by your average.

"Let's compare two orders using that 22% operating cost," Bruce said. "First, let's say that we had $100K direct-ship order with a 10% gross margin. Would it really cost us 22% – or $22K – to process an order that we don't really touch? While there are some expenses, including a salesperson's commission, that's really a massively profitable one line item event."

"Next, let's say that a big customer ordered a $10 item with a 50% gross margin," Bruce continued. "Are we to assume that the order cost us $2.20 to process? We know that it costs us $10 just to run the pick so it can't be profitable."

"Gross margin works as a summary or aggregate of your overall activity," Bruce said. "It can't tell you whether a specific sale made or lost money."

If you don't know whether a sale made money, you can't control the things that are hurting or helping your profitability.

"If you have a salesperson who has a contract with the headquarters of a chain, he could be bringing in good margin dollars and a good margin percent," Bruce added. "However, your company could be distributing small orders to all of the chain's individual stores and losing money on these orders."

Many distributors make the mistake of not monitoring cost-to-serve. They fall into a dangerous trap of assuming that any gross margin over a certain percent is good, and anything under that is bad. As a result, you'll wind up having a massive number of unprofitable sales because the cost-to-serve is higher than the margin while completely missing lower-margin sales where they could have made a lot of money.

Your company needs a cost-to-serve model and a system like WayPoint Analytics to see what your costs are on a customer by customer, order by order basis. It's the only reliable way to detect and repair sales profitability issues. Without these things, you could routinely miss opportunities and lose money on sales without ever realizing it.

For more information about Bruce's new Cost-to-Serve Math training course, visit: http://www.iklarity-courses.thinkific.com/courses/CTS-Math

For more information about Bruce Merrifield, visit: www.merrifieldact2.com

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