www.quantumprofitmanagement.com Quantum Profit Management
Gross Margin Fixation

Bruce Merrifield, President — Merrifield Consulting

•distribution management best practices •profit strategy •management strategies •Wholesale Distribution Industry •how to compete with AmazonSupply •distribution industry trends •new opportunities for distribution industry •cost-to-serve math •cost-to-serve in distribution •segmentation •LIPA

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In this video interview, Randy MacLean and Bruce Merrifield discuss how a fixation on gross margin – without looking at cost-to-serve (CTS) – has blinded countless distributors and limited their ability to achieve profitability.

"Gross margin and gross profit dollars have long been used as a surrogate for profitability," Randy noted. "Gross profit is an important number and certainly one you should watch. However, gross margin is another story. Through extensive research, we've concluded that gross margin is such an exceedingly poor predictor of profitability that it could be seen as having absolutely nothing to do with profitability!"

"The reality is that there are only two things you need to look at to determine whether a sale is profitable," Randy continued. "The first is gross profit. You need to focus on gross profit in sales because those are the dollars used to run the business and generate a return for shareholders. Revenue has nothing to do with that."

"The second thing, and other side of the equation, is the cost-to-serve dollars spent delivering the orders," Randy said. "From the math standpoint, here's the interesting thing: Gross margin runs 15-35%. Under no scenario can it get to 100% unless you're getting the product for the free and it can't go above that."

"However, CTS can go from 1% or almost 0% to 100%, 200%, or even 300% of the revenue on the order," Randy said. "Gross margin has a cap, but there's really no ceiling for CTS. More importantly, every sale has a gross profit dollar and a CTS dollar associated with it. You only make money when that gross profit is greater than the CTS."

"If you look at your P&L and could change anything by 1%, what would you choose?" Bruce added. "Raising that margin by 1% would increase your profits while buying low could help to improve the margin. However, when you start to think only in terms of margins you run into an absolutely fatal misconception and it's the belief that anything with a high margin is automatically good."

"From our own research and looking at WayPoint Analytics clients when they first come into our system, we've consistently found that on average 62.5% of all sales are money-losers," Randy said. "These sales all have one thing in common: The CTS is greater than the gross profit."

"The even more amazing and counter-intuitive thing is when you look at those customer rankings, the most profitable segments frequently have the lowest margins while the big losers are often high margin accounts," Bruce said. "Those profitable low margin accounts all have an even lower CTS and are very high volume."

"Distributors frequently experience profitability issues when they insist on only doing business over a certain margin percentage," Randy said. "There are companies that forgo some incredible deals because they foolishly insist on only doing business when there's a 15% margin. I recently worked with a WayPoint client who was getting a 1% margin on a $5m order – that's a $50k gross profit – that only had a few hundred dollars in CTS. It's easily one of their best deals all year yet some of their competitors would completely ignore it because of that margin."

There's no such thing as a magic number when it comes to gross margin because almost any margin percentage can be good if it has an appropriate CTS. By relying too heavily on gross margin, you can miss out on incredible opportunities.

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

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