Julian Dent, VIA

by Stuart Wilson, Wednesday 25 November 2009

Gross margin can be a dangerous measure in recovery times. Channel expert Julian Dent from VIA explains why. Dent is chairman of VIA International, a specialist routes to market consultancy.

Gross margin can be a dangerous measure

For most companies, the gross margin is one of the most important measures of business performance. In this article, we are going to show you why it could be the most dangerous measure during these times of possible recovery from the recession.

How can that be? Surely all profit is good, so more is better, right? Well, as economists like to say, it depends…

Take a distributor, dealer or a retailer selling two products that happen to have identical gross margins.

One (let’s call it a Widget) is a well known brand that practically sells itself, virtually never gets returned, works just the way the customer expected and comes in a square box that stacks neatly up to six feet high.

The other (let’s call it a Sprocket) is new in the market, often gets returned because the instructions suffered in the translation - and frankly it isn’t that reliable anyway. It comes in some fancy packaging that involves several see through plastic bubbles and can’t be stacked.

You’re probably ahead of me here, but which one actually makes the most profit for the retailer? The Widget, but hang on they make the same gross margin. How can that be?

The concept that applies here is called the contribution margin and it takes into account all the ways a product affects the dealer or retailer’s operating costs. So the Sprocket makes a lower contribution margin because it incurs:

• a higher selling cost because it takes more time to sell as no-one’s heard of it before.

• a higher product support cost because customers keep asking how to make it work.

• a higher reverse logistics costs because it gets returned a lot.

• a higher warehousing, shipping and display cost because it’s awkward to handle, takes up more room and space in the supply chain and in the store.

In retail, these costs are called direct product costs and they are deducted from the gross margin. In other channels they are recognised as variable costs. Either way, the contribution profit, calculated by deducting these costs from the gross margin and the contribution margin (contribution profit divided by sales revenues) reveals the true picture e.g.

Sales 100

Minus Cost of goods sold 75

= Gross Profit 25

Minus Variable costs 11

= Contribution Profit 14

Why is this so important in recessionary times?

The contribution margin is so called because it is about measuring the contribution to fixed costs. And in difficult trading conditions, it is the fixed costs that cause the problems because the lower level of sales can’t generate enough profit contribution to pay for them all. (Being fixed means that it usually takes quite some time before you can take action that will reduce these costs, which include payroll, rent, depreciation etc).

If you were to focus only on gross margins, you might think it didn’t matter whether you sold Widgets or Sprockets. The contribution margin tells you that you will make a much bigger contribution to fixed costs if you sold more Widgets.

Obviously as long as a Sprocket makes a positive contribution (i.e. it has a contribution margin >0) then it’s better to sell a Sprocket than nothing. But if you can influence the customer, you’d want them to buy a Widget instead of a Sprocket.

So what can I do if I am a Widget or Sprocket vendor?

The easiest thing you can do to improve the contribution margin is to improve the gross margin. This might mean offering higher discounts to the channel or greater rebates (in return for increased sales volumes).

After that the best thing to do is to help with the marketing costs in the form of funding or special allowances. These could be tied to performance such as including it in special promotions, putting the product on prominent display or in special locations.

Alternatively, the funding can be directed into special programmes that focus customers on your product (but if the dealer or retailer incurs increased costs that you simply reimburse, then contribution is not improved).

Finally you can bear some of the channel costs, such as the reverse logistics or product support, which work very directly on contribution; or increase brand advertising and promotion to increase consumer demand, which works on lowering the cost of selling.

Is contribution margin the best measure to use in times of recovery?

It’s certainly the best return on sales measure because it gives the best indication as to whether a sale will generate operating funds. At the DISTREE XXL 2010 conference, I will show the best overall measure is a specific type of return on capital measure; and as we know, capital is in rather short supply just now.

DISTREE XXL 2010

Julian Dent is participating at DISTREE XXL, which takes place in Monaco on February 8th to 11th 2010. For full details on the event, please visit www.distree.com/xxl

DISTREE XXL gathers 400-plus senior executives from EMEA’s Information Communications Technologies (ICT) & Consumer Electronics (CE) volume distribution channel. During the course of the three-day event, delegates take part in thousands of pre-scheduled one-on-one meetings with hundreds of vendors. Each year, hundreds of new distribution agreements are struck across EMEA as a result of business relationships initiated at DISTREE XXL.

DISTREE XXL 2010 will also build on successful initiatives launched at last year’s sold out event including a regional awards ceremony. The ‘EMEA Channel Academy: 2010 Awards’ will include more than a dozen awards handed out to vendors and distributors from across the region. www.distree.com/xxl

Follow the build-up to DISTREE XXL 2010 www.twitter.com/distreexxl

Julian is chairman of VIA International, a specialist routes to market consultancy. He has over 25 years experience in distribution throughout the world, specialising in channel strategy and implementation, working at global corporate and regional levels.

His clients have included HP, IBM, Intel, Microsoft, Nokia and Xerox. Julian’s speech at DISTREE XXL will focus on what is required to survive the coming shakeout, explaining the key ways to make it through the credit crunch and thrive in the new distribution landscape.

If you want to go into these topics in more depth, check out Julian Dent’s book ’Distribution Channels – Understanding and Managing Channels to Market’.