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Improving gross margins.

Amanda Line, Regional Director, ICAEW Middle East

The willingness of companies to provide credit to their customers has reduced significantly. So, if you are able to offer cash on delivery to your supplier, you may be able to negotiate a discount on the price of the goods

Pilferage is roughly estimated to represent 2% of a retail business' turnover. That represents a potential increase of over 10% in the gross margin if it could be eliminated

No business performance measure is more universally recognised than the gross margin. What is it and why is it considered so important? Amanda Line, Regional Director, ICAEW Middle East, explains why it is the golden goose of business.

The gross margin is the value of sales less the direct cost of sales. In other words: if sales are AED 2,000 and the cost of sales were AED 1,200, the gross margin is AED 800 or 40% of sales.

Why is this so important? Put briefly, the higher the gross margin, the more profit you can make. That might sound simple but it is also a means by which different businesses can be compared. If a jeweller's gross margin is 50% and a tour operator's is 20%, the later has to sell two and a half times as much value to achieve the same gross margin. So, gross margin is a unique basic comparison of differing businesses. Not only does it allow for comparisons across sectors but also across country borders.

Furthermore, to calculate the profitability of a business, all you have to do is deduct the business' overheads from the gross margin. If the gross margin is AED 1,000 and the overheads are AED 600, the net profit is AED 400. Overheads tend to be fixed in the short term, so gross margin becomes a good indicator of profitability and can be calculated quite easily.

Since the start of the financial crisis, the pressure on gross margins in the Middle East Region has been intense. As demand has fallen in most sectors, it has been increasingly difficult for businesses to maintain their gross margins and many have had little choice but to reduce selling prices, thereby having a significant impact on their bottom line. The more important question therefore, as the regional economies slowly start to find the business environment improving, is how to start to rebuild and improve gross margins. There are several ways discussed here. What does each of these entail?

Increasing selling prices

Most SMEs have a constraint on how much they charge for their products -- quite typically dictated by the recommended retail price or the cost of specific goods. However, in most cases the greatest influence on a business' selling prices is their perception of "what the traffic will bear". In the case of retailers, location plays an important role -- such as the proximity to competitive outlets, and nature of trade (regulars or one-off sales). But there are occasions when an opportunity (such as a particular product shortage) allows either a temporary or permanent increase. It is occasionally worthwhile to increase prices, at least on selected lines, to establish what the effect on demand is.

Reducing the cost of purchased direct materials

Reducing the cost of input prices depends largely on your "leverage" over suppliers. If you are a major customer, you can secure significant discounts. If you are a small customer, representing no significant share of the suppliers' sales, you are unlikely to be able to persuade them to charge you less. However, in the Middle East in the last 18 months or so, the ability or willingness of companies to provide credit to their customers has reduced significantly. This means, if you are able to offer cash on delivery to your supplier, you may be able to negotiate a discount on the price of the goods in return. Alternatively, belonging to an organisation that offers the advantage of bulk buying, such as a big chain, could help in negotiating down buying prices.

Improving the sales mix

If a business sells two products, A and B, and product A has a 30% gross margin and product B a 20% gross margin, then the overall gross margin will be increased by selling more of A and less of B. If, however, a new product -- C -- can be offered at a 50% gross margin, it is clearly beneficial to sell it, provided it can be encompassed without increased overheads. In tough economic times it is even more important to focus resources on areas of the business that offer the greatest return for the investment in overheads. SMEs need to be quick to recognise which of their product lines offers the highest gross margins. They also need to be equally quick to react and adjust the product mix to maximise margins, when this can be achieved without any overall loss in revenue.

Reducing waste, write offs and pilferage of stock

This is the area where most businesses can make significant gains in their gross margin percentage. Pilferage is roughly estimated to represent 2% of a retail business' turnover. That represents a potential increase of over 10% in the gross margin if it could be eliminated. With those possible gains, it is worth considering all the security measures available.

Careful planning and forecasting are important tools so that levels of production and stock are enough to meet demand but not so high that the businesses have to offer a discount on unsold goods or throw out perishable stock after its sell-by-date, as this will also adversely impact gross margins. The sudden change in the economic environment in the Middle East during 2008 and 2009 meant that accurate planning and forecasting has been hugely challenging. Many businesses have been left with significant unsold stock and have had to reduce prices and offer deep discounts in order to achieve sales. As the business environment starts to improve and growth in some sectors returns, accurate forecasting and planning remains a vital skill for ensuring that business output matches demand, but does not result in over production with a subsequent reduction in gross margins.

Introducing new lines or services

Businesses should periodically review all their major product lines or services. The review should include what proportion of sales the products represent and whether they contribute enough to the gross margin. Important questions to ask include: Should you drop some of the lower gross margin products or services? Are there other lines which could be introduced to offer a greater margin? What will your customers' reaction be? Will it bring in a new range of customers? What other consequences would follow? Many businesses in the Middle East have demonstrated great flexibility in this regard recently and shown that they can change their business models to maintain their profitability, despite uncertainties in the market place.

Whatever the business situation, gross margin is a key indicator of business success. Make sure you take the right steps to maximise your business' potential. And if you need help, speak to an expert, such as a chartered accountant, who can offer an outsider's view of your business -- and perhaps help detect some of the trends and questions that you might miss when you're up to your neck in it day in and day out.


Amanda Line was appointed as the Middle East Regional Director of the Institute of Chartered Accountants in England and Wales (ICAEW) in September 2009. The ICAEW provides leadership and practical support to over 132,000 members in more than 160 countries, working with governments, regulators and industry in order to ensure the highest standards are maintained.

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Publication:SMB Advisor Middle East
Date:Oct 12, 2010
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