Episode 21 – The Growth Whisperers
The Growth Whisperers is a weekly podcast hosted by Brad Giles and Kevin Lawrence two advisors to mid-market businesses, one Australian, one Canadian, who each work with CEOs and Leadership Teams across the world with a mission to build enduring, great companies. Each weekly episode covers interesting situations and questions from the world of strategic planning, leadership development, talent and hiring in high growth entrepreneurial companies where real results matter.
Gross Margin – Understanding the most important number in your business
This week on The Growth Whisperers Kevin and Brad talk about the most important number in business – Gross Margin, and why it’s the output of a great strategy, how to understand your Gross Margin and what to do when you see a declining Gross Margin. Also they talk about how sales people affect Gross Margin, and what to do about it, as well as provide simple tools to analyse Gross Margin and one tool to bring discipline to, and turn around Gross Margin erosion.
Kevin Lawrence – Lawrence and Company Growth Advisors
Brad Giles – Evolution Partners
YouTube – The Growth Whisperers
Episode show notes
Brad Giles 00:13
Hi there, welcome to the growth whispers where everything that we talk about is building enduring great companies. I’m Brad Giles and I’m joined today by my co-host, Kevin Lawrence. Kevin, how you doing today?
Kevin Lawrence 00:27
I’m doing awesome Brad. I’m really looking forward to the show today.
Brad Giles 00:32
Awesome. Have you had a good week up there in Canada?
Kevin Lawrence 00:36
I have I got away into the interior we have an Okanagan region where the cities by the name of Osoyoos and so use and was up in Kelowna last night. I mean, it’s so use right now before I head back to Vancouver. And it’s just it’s a beautiful spot in the summertime just love being up here. It’s relaxing and, and good times with friends and getting out of the city. So yeah, it was really great.
Awesome. So what do we got on today? What are we talking about?
Kevin Lawrence 01:02
What’s a day we’re talking about one of my favorite, favorite numbers in business. I know they say and, you know, if you have kids or parents, you’re not supposed to have a favorite if you’ve got, you know, two dogs or two pets are not supposed to have a favorite. But this number called gross margin. And gross is almost a funny sounding word, you know, like gross, and, you know, not pretty, or, you know, ugly. It’s a beautiful thing. I I love gross margin and in companies finding ways for companies to make it stronger. And because from my perspective, it’s, it’s really the number that tells you how good your value prop and your running of your business really is how well you can buy, how efficiency how efficiently you build or deliver, and then how well you sell and create value for your customers. It’s a it’s like the ultimate measure, I think of how smart you really are in business.
Awesome. It’s my favorite number as well and to be honest, if you’re in business, it probably should be your favorite number or maybe after cash or something like that. But one of the, let’s say top three favorite numbers. So maybe we should begin by just defining for the audience, what is gross margin, and maybe just so we’re all on the same page, because gross profit for me is very different from gross margin.
Kevin Lawrence 02:29
So let me give you the did the technical description from mine, we can take yours, blend them together into one. Basically, let’s just say we are a business that sells a bottle of water, water bottles, right. And gross margin if we sell a case of water for simple numbers $5. And our cost is $2.50. That means we have a gross profit, theoretically at that level of $2 and 50 cents, which would translate into a 50%. Gross Margin is the revenue that you get to keep after you pay for the expenses is 50% of the revenue. So gross profit is the actual dollars, the number of dollars, the $2 and 50 cents. And it goes margin is the 50% in simple terms now, that would be the cost of the bottle and the water and you might have shipping costs and all the other costs related to the sale of this particular bottle of water, not just the physical there will be no other costs wrapped around it. But yes, that’s how much you make on the things that you sell. And whether it’s counted in dollars called gross profit are countered in percent called gross margin. Yeah, my version of it, I’d love to hear a different view if you have one nearby.
Brad Giles 04:04
Now, it’s exactly the same. And what I would say is a lot of people get confused between gross profit and gross margin and that express gross profit is a percentage, which is it’s not it’s $1. So or a currency. So yeah, I definitely agree with that. The only the murkiness can sometimes come when people begin to talk about labor that I’ve observed. My definition is the same of yours. Same as yours. So labor is in the equation, or let’s say direct labor. Okay, so employee labor, then they’ll all be below the gross profit or gross margin line, there will be all we talk about that later on. So the labor to make the bottle of water, it wouldn’t be counted. That’s we talked about that later on. It depends and the answer is it depends on how people account for it because people do account differently. When It comes to call it the variable labor or the direct labor on it. Yep. Some have it in there and some don’t. And that’s the things. And we I guess for today’s exercise, we want to just keep it fairly simple, knowing that some people have some different kind of standards. But broadly, the, the best way to look at it is, what is the cost of goods, the goods, if you’re reselling them, what is the cost of those goods, that’s where Cost of Goods came from.
Kevin Lawrence 05:34
And so if you take a service example, you know, in a consulting model, like we’re a part of, if there’s a project, that’s $100,000, and after you pay the people, and the research expenses, and the prep expenses, and the administrative expenses, all of the costs to deliver that hundred thousand dollar project get deducted. And then you’re left with your gross profit or gross margin. So everything around the service delivery, what you don’t have in there is your overheads. Technically, in accounting terms, it’s called your SGNA. Or your GNA, or overhead. sgma is sales general and administrative expenses. fancy word for overheads. GMA is general and administrative expenses. When sales isn’t counted as overhead, it’s counted more often in gross profit. So anything that basically your basic rent, your accounting department, and all of these other departments would be general and administrative. overhead. And those are in there, because they’re those are bills you’re paying no matter what, whether you make one or don’t make one.
Yeah. Okay, so we’ve got the base, we’ve defined what it’s not, it is essentially what is the cost of goods as a proportion or ratio to the total revenue? So it’s the percentage to why have we both said that this is the most important number, like, what’s your thought on that?
Kevin Lawrence 07:11
Because we’re smart. No, because we’ve, we’ve been in so many companies, where you watch it a road, and then people’s ambition to grow, and their naivety because people tell them, oh no you need to give up your gross margin as you grow. That’s someone who doesn’t understand business, it can be a strategy, it can be a strategy to lower your margin and get more volume can be, but we both look at some of the best companies to work with who have healthy margins and keep them because and we could talk about why but the root of it is, is it has such a direct impact. And an extra dollar of gross margin of gross profit is is an extra dollar of profit. If I charge one more penny for this bullet one more penny that Penny goes to profit. Yep. In almost every case. So it just, it’s so impactful. But what happens is it starts to fade. It’s the way that you can evaluate new products, or services or divisions. But if not attended to, when people get all excited about revenue, all revenue ain’t created equal. Yeah, there’s revenue that you can make a 45% gross margin, a 15%, gross margin and an 80% gross margin. And if you don’t pay attention, and you chase dollars, or just revenue, by nature, if you’re not calibrated around gross margin, you’ll almost always dilute it. Because lower margin deals are often easier to get it’s reducing your margin to get the business isn’t doesn’t take a lot of brain power. Yeah. So it’s very easy trap to fall into.
So one of the things that I’ve done insane is sales people who discount, right. And often that’s because there’s no disciplines around that. And the It seems so intuitive that a salesperson with all of their bravado and confidence will go into a meeting. And they job in their head, especially if they’re not compensated around gross profit if they’re compensated around revenue, right? They will go into the meeting as if their job is to win the business. And then I will talk to the client Now obviously, the client in their best interest is to get the best deal. So the output of that meeting might be that there’s been a discount and they’ve said, Look, we gave him a 10% discount. But the awesome news is we won the deal, but the cost of that is enormous.
Kevin Lawrence 10:04
To the company, but not to a sales rep paid on revenue. Absolutely, they don’t care. And that’s why we’re there’s variability in pricing. Sales Reps should almost always be paid on gross profit. Yes, because now we’re in it together, if they have zero control over pricing, and cannot discount or cannot make a decision that will influence margin, you can pay them on revenue, there’s no risk, like, go get all you want. Because we know it’s going to go between 27 and 29% margin because that’s our model. But when they have choices and negotiating power and all that stuff, now we need to align our interest with the company. And if they can help the company to win more than then they win more. And I think the root of it, and this is where compensation is really very aware of it. And compensation is a whole other world. But the biggest thing I’ve seen that’s most people want to do the right thing for the company. The challenge is that there is no gross profit or margin awareness in the business. And this is what we see. And this is why it erodes is so for example, we have a business that used to run around 25%, gross margin 25 cents out of every dollar they would get to hold on to and then you’ll pay their overheads and then have a profit. Um, what we realized is they had you know, a couple hundred salespeople not quite know how to 100 are salespeople, and some service people, both of which had pricing decision authority, and they would just get the business. And we came up with a calculate because that’s, you know, a lot of salespeople aren’t mathematicians, some are, but many aren’t. And so we came up with something called we called it a green start calculator. Green meaning good start meaning new piece of business and calculator. So you would drop a couple of numbers, you drop a cost number in and revenue number in and the end, it would tell you the gross margin percent, and it would be red, yellow, or green, red means you got to fix something, you either got to buy a little bit cheaper or you got to charge a bit more yellow would mean close green would be a man or a lady woman, you’re in the money. So we trended up toward towards 28%. Very quickly remember, three extra percentage of gross margin means three extra percent of profit, it falls to the bottom line instantly. Yeah, because we had awareness on every deal they did, they had to use the calculator. And every deal they did, if it was red, they couldn’t put it through yellow, they were encouraged to or their manager had to make a decision. But if it’s green, go, and so teaching people about it and giving them awareness made a notable difference.
And that’s a really important point. Because the place where you lose gross margin is in the estimating department or the sales department, like depending on the structure of your business, assuming that there is variability. Because if you’re a grocery store that doesn’t do any discounting, it’s just that’s the price. That’s the RRP recommended retail price. You’re not really gonna you’re gonna have other issues around purchasing, but it’s the estimating. So it’s similar thing to what quite funny that you said that similar thing that I’ve done is you start with a client, and then you say, so what is your gross margin for last year? What is that? And they’re gonna say, okay, so it’s 56%, nominally, let’s pick a number out of the year 36% was your gross margin. What I want to do is every quote that leaves the quoting department, I want to color it. And if it’s 56% plus five, taken 56 to 61%. It’s a green file. If it’s 5% below that, it’s Amber. Okay, so 56 to 51% would be Amber, anything below 51 would be red. Okay, and you need to get the directors signature on that to actually send that out. Perfect. Yeah, if it’s so you’re doing the red, Amber green, super green across what was the gross margin percentage for last year for the whole business and it kind of, you know, it’s like the tide lifts all of the jobs a little bit, or at least the ones that aren’t so good. And then again, what we’re doing is for a red, sorry, an amber, we’re kind of justifying, saying, you’ve got to have justification and you’ve got to have sawn off from your manager. But then you’ve got to have director approval for the red and then it just it magnifies the impact on the business just by looking at it like that.
Kevin Lawrence 14:53
Well, of course, because you’re slowing down the process or creating friction. If there’s going to be a discount or If they’re not pricing it right in a code center. So people want to do the right thing. But you need a system to help them be reminded of the right thing. And I’ll tell you, Brad, like, there’s lots of examples where we have increased gross margin in many, many, many companies we work with. And yes, it would be easier to keep the margin lower, but we want to be great operators. You need great margins to fund other things. There’s other things that we also look at, too, on the cost side, you know, efficiencies and automation and managing the numbers. One of our clients has an amazing CFO that’s x, I believe, Procter and Gamble or a Procter and Gamble like packaged goods company. So we I mean, I’m a gardener, I’m a gross margin freak, we have what you call a gross margin bridge, it shows a gross profit bridge, pardon me, it shows what the gross profit was supposed to be for the quarter say it was simple numbers $10 million. And then it shows every item that either went up and increased it, or decreased it by line item of the income statement, you can see the things under this company, there was a variable labor piece that was really driving it, it was a lot of overtime and inefficiencies in their facility. But so we have our quarterly reviews, we have gross margin bridges to show the specific items that were driving it and getting into the detail. Was it because of volume more or less volume? Was it because of mix the different products having different margins and how it affected it? Because that could be an underlying driver? Or was it because of price rate, ie a cost factor or a revenue factor? So we slice and dice it from all of these different angles, and we find ways to make it better. And so the thing like you said, Brett, I love it is that, you know, often when I start with a business, and if there is an issue around gross margin. By the way, I’ve seen some businesses with crazy cross margins like, like you almost don’t want to tell people, I met a couple businesses in industries that have low gross margins. And they found ways to get like 65% gross margins in hard goods, you know, manufacturing type scenarios, because it’s a very special nice with nature, the big pain point. But going back to when it does erode, I get them to go back and do a historical 10 year comparison. Yeah, let’s look back 10 years and see how the gross margin Did you know sometimes then that we’ll do a unit view of you know, do number of units, obviously, total revenue, but we’ll look at gross margin, and then sort of start to dissect it and see where we went wrong. I can learn about gross margin for hours. We’ve worked on it from sit and it’s like, it’s this like, weird accounting number, but it’s like, it’s at the core of the business.
I want to go back to so I want to go back to this slicing and dicing. So that’s why I think that what you described, as what we’d call a waterfall graph.
Kevin Lawrence 18:14
waterfall would show all the different products and their margins? Yeah, in the direction of waterfall, but it’s actually called a bridge. It’s a different.
Brad Giles 18:24
It’s a different take on it. Yes, yes. So are seeing the bridge. So a bridge graph and, and slicing and dicing it, because so many, and it kinda is going to it’s going to connect with what I’m going to speak about in a sec, which is about the strategy and the sales people. But when you understand what are the areas that your business isn’t contributing to gross margin, like which lines that you sell or product. That’s where you get the real insight that can make the biggest difference is a retailer that I work with when they’re like a 50 year old business. And I went in there and I said to them, Look, if you’re not making 10% profit, you are, you know, you’re not your effort isn’t worth it here. And they said, You’re crazy like we this business is 50 years old, we’ve never made the best year we made like 4%. And I’m like, Well, I don’t want to say that you’re wrong. But there’s a good chance you could be like it’s actually possible. And so we had this kind of interesting and I said look, if you’re doing less than 5% you’re growing broke, it’s as simple as that you’re not keeping up with all of the cost increases, you’ve got to have 10% as a minimum goal, but that’s the output of the leadership team effectively is to produce a return for the shareholders and to grow the equity of the shareholders. So anyway, I come back and we did this bridge and we looked at the gross profit per line and we looked at the strategy and we focused on that and now they are wedded to this 10% number like there is no tomorrow. And I said, Look, we just until you actually challenged us on that we never believed in our industry that it was possible to get there. And now we can see it as clear as day. And it’s like, that’s because it just, you didn’t have a strategy. And you were selling things that you thought people wanted or needed at a price that you think that they had, which is fine, you’ve got to do the right thing by the customer. But unless you understand those numbers, you don’t know what to do.
Kevin Lawrence 20:32
Right? You are my brother from another mother. Like I’m listening to you talk, I do the same thing all the time. I press people in saying, because I see businesses making 10,15 20,25,30, 35% profit in sale could be profit could be EBITDA, but massive profits in businesses, you would never expect it because they know how to run the damn business. And that gross profit or gross margin number is one of them. So I’m like I’m with you. We started setting the bars the number of years I took a business that I worked with that was running 18%. I didn’t they did the work, I set the challenge and the strategy to do it. Where they were running at 18% gross margin in a business. Yeah, and but we got them into the healthy 20s 26, 28 in the business that normally runs in the low teens, and at good volume. So we found over the years, I have done many, many things, the root of it is make a decision, and then start to really dig in and figure out why. And then how could we, you know, go and get to 30% gross margin as an example, if you’re running 22. And over a number of years, I’ll give you an example of something we did, I’ll keep it generic because I don’t want to give away the details. But I have a client, they were running lower 20s in the gross margin, but they were in the 20s. It was decent. We knew to really optimize the business, we needed to be around 30. That was my take on it with the way they ran, etc. First of all, we got comparables in their industry data. Because there was some publicly traded competitors, industry data, and we saw that the best was actually running a 40% gross margin. Although they were a niche player, they were a massive niche player. So it was like, Hey, boys and girls, it’s available. It’s possible. Let’s go after this. So we started doing some strategy work on it and found a particular pain point that no one could seem to solve in the industry. And it’s a service business, that if we solved that particular pain point, we could probably get 40, 45% gross margin. Yeah. And so we started doing it. The only problem is, is that worked so well. We got distracted by it a little bit and neglected the core business. Because there’s these big fat margins driving massive profits. And it distracted a little bit. And again, it’s straightened it out everything else. But it’s it was just about looking for those needs. I’ve got another company I work with, I don’t work with myself, but indirectly I work with, and I actually invested in a friend of mine was buying this business. And I put some capital into it. And I don’t even want to tell you the margins, they won’t tell you the profits. But it defies logic in business. Yeah, most people don’t think most people think that you can only make five or 10% profit in a business. And that a 20% margin is really healthy and be depending on the industry. But I have seen things that would just blow your mind. But they’re doing something different that they’re uniquely solving a customer need. There’s there’s it’s not commodity stuff, generally
That’s a really important point because all business models aren’t created equal. No. And if you find yourself in a commodity business or a business with low margins, the job of the strategy work that we do that even if we don’t work with an advisor or a coach, the job of the leadership team is to produce a higher return on effort for the assets and the people that are in the business. You
Kevin Lawrence 24:26
are not always increasing the gross margin to be fair, sometimes it is running a commodity strategy and increasing volume and dropping your overheads or better leveraging your overheads with much more sales velocity over the same overhead or automating things there can be we just tend to work with higher like a more value added focus companies that want to be you know creating a premium experience premium product and have the margins to go with it. But you can mean you can’t played the run the commodity playbook at low margin, you just need to have a very different strategy.
But if you are, if you are running the commodity playbook, you’ve still got to watch gross margin really closely.
Kevin Lawrence 25:18
You had more so because of the thinner yeah, absolutely the good, good point bread, it’s they are thinner. Can I offer one different strategy even another layer on this? Or do you have something else you want to share on gross margin?
Brad Giles 25:32
Kevin Lawrence 25:33
even though I am obsessed with gross margin, all margin is not created equal. I’ll share an example. When I worked on the scaling up book project, and I interviewed 50 CEOs around the world for that. They were using Rockefeller habits at the time one of them told me about their business and an epiphany they had, they had their number two clients by volume, right, and they were doing a lot of volume with their second biggest client that had an above average gross margin. Right? Take their average margin, if you did a waterfall graph, they would been above average. Yeah, when they did the full math and allocated the overhead costs appropriately. They were losing money on their number two client by volume, who had an above average gross margin. And here’s why. And this is incredibly important. Because if we’re running at a 24, gross margin, there might be a customer or a scenario you could sell at 20. And make more profit. Yeah, hear me out. Because this client was massive. I’m exaggerating, but they essentially consumed, you know, if they were 10% of the organizations revenue, they consumed 50% of the executive time, leaders time and managers time because they were such a mess, and complicated, they were a huge administrative burden to service them. So it would have only represented 10% of their revenue, conceptually, yeah, soaked up 50% of the overhead of the business to service them. So when you take the cost of that overhead, you’re losing money on the client. So you need to be aware, and we run models on this on clients to dial it in even further. I need to be aware of how much margin it takes. I’ll give you an example. So if we sell water bottles, and we manufacture them in our facility, and then we shipped them to a client just for simple things. And we make a 50% gross margin. If we could import them by the container load, never touch them, and have them delivered to our customers. Would it be smart to take a 15% gross margin potentially? The answer’s yes. When you can make 50% on this, why would you consider 15? Because this will soak up a lot of overhead of that 50%, I’m going to exaggerate 20 or 30% of that 50 will go to overhead.
for those who aren’t on video, just so don’t stop. Kevin’s holding up a water bottle and product.
Kevin Lawrence 28:31
Thank you, Brad, I really forgot to think about that. So basically, you’re just signing pieces of paper, or it doesn’t touch your building, your humans don’t touch it. You’re making basically that 15% gross margin is actually 15% profit, because it’s the only thing you might have as a touch on it for accounting. So pull 1% out. So there’s so it’s 14% profit on 15% gross margin because it doesn’t consume overhead. Yeah, this is the advanced level of slicing and dicing gross margin is how much of the organization energy organizations energy resources does it take. So that’s a, that’s a, you know, direct shipping from a vendor model. But even internally, you know, there might be a customer who takes stuff by the truckload, but instead of the individual order, there might be a customer that only orders one product and orders massive amounts, versus another customer that has a lot of customization. There’s one customer is fully integrated into your systems electronically. Another one uses papers and you have to manually do things or they make mistakes all the time or they require more compliance or paperwork or they’re in another country and you have to export. Like there’s all these other variables that all know that allocating the overheads appropriately to them can tell you a very different story.
Brad Giles 30:00
Yeah, that’s a really good insight. And so it’s, there are many complexities to it. But it still, I think reinforces that this is the biggest lever. This is the biggest tool that we’ve got. And yeah, the one that we’ve got to pay so much attention to. So there’s two questions that I want to cover off today as well. And number one is why what how does gross margin relate to strategy? And if you’ve got a good strategy, why should you see an improving gross margin? And the second question is about sales people.
Kevin Lawrence 30:43
let’s do the strategy one first.
Brad Giles 30:45
Does that just to clarify, the second question is, it’s just about lazy sales people? Right. And we did touch on that before, I want to just dig a little bit deeper into that reschedule act.
Kevin Lawrence 31:01
Well, exactly right. Because so this is when you’re, for example, when you are looking at new products or services, one of the initial parts of the business case is what’s the margins gonna be, you know, I had a client that was creating all kinds of Awesome, cool new products, like they were awesome. Well, their margin generally runs in the higher 20s, these exciting new products on paper in the planning stage, we’re coming out at 20. I’m like, kill it, go back and get it come up with a better idea. If on paper are showing 2018, you know, reality kicks in, you lose a few points for sure. The new product should have been coming out at 40. Like, why do we want to invest into r&d on something that out of the chute makes us less money, and there was no strategy that it would grow and make more money in the future. So on strategy, and that’s why I think gross margin is an indication of your strategy, how good it is, you’re looking for those things that will meet needs where you can, you can do something special, and either they’ll pay premium, or you’ve got a cost angle that allows you to have really low cost or cost advantage.
Brad Giles 32:16
Sorry, go on finish.
Kevin Lawrence 32:19
For sure it is so so so whether it’s a new product strategy, new markets, trying to go into a new market, great, what are the margins look like? Let’s find out let’s do a test. Because if you’re not conscious of it, all these nice ideas, if they make less money than what you’re doing now, they’re something’s not right. Or Yeah, you know, or it’s not worth it. There’s a other factors in the market that make it less attractive.
Brad Giles 32:46
So you’re presented with a set of numbers 12 preceding quarters, the last three years of quarterly results, and you only get the gross margin percentage, the gross margin. Like what is that? And that’s, that’s eroded about one to 2% per year. If you’re presented with those numbers, what’s the first thing that tells you? w
Kevin Lawrence 33:18
I’ll have another 10 questions, because it tells me to pay attention. Absolutely. And it tells me to investigate, because there’s so many other leavers under the surface there. I’m curious about the volume. I’m curious about when we break down the cost side, I’d want to look at all the every line item of cost to understand, you know, what, which lever is creeping, right? And is it a, is it a sales price? So I’d be looking at average price per unit backing out inflation? Has the average price per unit changed? Or has the cost per yard? So just it’s slice and dice time boys and girls? Yeah, we’ll begin to see what’s going on? Well, as a failure, it’s failure unless, I mean, you might justify it if their volumes went up 10 X, but I’d want to know that. And then it also want to look at a corresponding with the bottom line. Because if they were getting better leverage on their overheads, ie sgma, was running at a lower percentage, or overhead at a lower percentage. Like I got to look at the whole picture. But I’m going to be really curious and concerned, for sure. And as an example, you know, I read an article with Intel, the chip manufacturer, right? Yeah, they’ve been around forever. You could say computer chips are almost commodity like, yeah. If you ever heard of what Intel’s gross margin is? chips, what is it? Now verify this for yourself. And I did research it was a credible source about two three years ago. 80% Wow, eight, zero percent on a manufactured item that would be considered. Now Intel has a beautiful strategy of how they do it. There’s Yeah, energy. And that’s a whole other. Their strategy is brilliant. You know, Jim Collins talks about their strategy when he shares this flywheel, it is outstanding. And they’ve dropped other product lines along the way to invest here because they saw the opportunity. But they’ve been around for a long time, they do a lot of volume, and they’ve held at 80%.
Brad Giles 35:33
They’ve got to spend a lot of money below the line to maintain huge market share on r&d. And the other thing in terms of sales tactics, the beautiful thing that they did, is they paid for their customers advertising, if it said Intel Inside, I don’t know if it was 100%. But I know they paid a huge amount and that was a really effective blocking strategy for their competitors, as well.
Kevin Lawrence 36:05
There’s a whole case study that we can do. So if we get back to your question, I’d love to hear your thoughts on it. Brad, what would you do if you’re presented a set of numbers enter the trend over a period of time it kept dropping one or two points? You know, what, what would you be thinking and or doing? Look, I’m gonna go to the two things.
Brad Giles 36:21
What is, what is your strategy? But really, I’m going to want to, I guess, as a part of that question, I’m going to want to know, what are the How do you sell and is discounting a part of what you sell? Because if you’ve got a sales team who want to hit their numbers, and they’ve got the ability to discount, or if you’ve got an estimating or pricing team, if there’s any price fluctuation, I’m going to look really closely at that and try to understand what are they doing? And is that the root cause of this gross margin erosion? Because it’s, it’s enormous. Like, if you’re having one to 2% per year, the impact on net profit is just phenomenal, right? It’s
Kevin Lawrence 37:05
if it’s 100 million dollar business, two points of gross margin, assuming nothing changed around your overheads. That’s one to $2 million of additional profit and cash.
Brad Giles 37:18
Which is unbelievable, like, and people just many business owners, they just don’t understand. I think I understand but they just don’t respect it enough, or they don’t investigate enough. So first of all, I’m looking for the I’m trying to put a fence around that. And if that’s it, that could be the first answer. But then, here’s an interesting thought, which is the second thing I’m thinking about? It’s around strategy. So you know, the question is, is your strategy growing revenue and gross margin, because if it’s only growing revenue, then, okay, it’s not a strong enough strategy. If you if you can’t even maintain it, let’s say, once to grow a business, you go from zero to a million, 1,000,005 million, 5 million, 10 million, 10 million or 20, I reckon when you get to about $10 million. That’s when the competitors look across to you, and you’re on their radar. And they begin to say, Well, we’d like a piece of that pie. And the competitive pressures within the market can erode margins, but plus your you’ve got an established leadership team by $10 million, most likely on the average case. And the competitive pressures to grow, if it’s not focused on gross margins can erode that as well. So there’s a couple of things when you get to that kind of point, that can have an impact. Because if you’ve got a $1 million business and your competitors got a $10 million business, it’s very easy to fight on price alone and to go to the market for that $1 million competitor and try to steal business because you could double your business by winning $1 million worth of work. So I’m looking at number one, what’s the pricing? And is the pricing eroding, causing that erosion? Number two, for sales people? I’m sorry, number two, is it market forces? Is it easy? The strategy simply not strong enough? That’s the two kind of things that come to mind.
Kevin Lawrence 39:17
Or has the product line faded and no longer relevant? Right, like maybe the product line has lost its pizzazz or it needs a refresher on a repackage or, like there’s so many things. Yeah, but looking at the pricing and yeah, we’re losing are we are we not getting the right pricing or our costs going up like this? It’s kind of fun actually digging in and figuring out so let’s talk about the salesperson part of it Brad.
Brad Giles 39:42
Yeah, so I owned an IT business and I had a general manager there who will remain unnamed and i remember saying that we were selling products, we were selling servers and things like that. And they had a recommended retail price. And we had, we had very good relationships with customers and our offering was really strong like we weren’t, we were just a small bit player in this business. And I said to him, when someone comes in and buys a computer, why are we discounting it? You know, why do we automatically give them I don’t know, $600 off a $2,000 computer, when it’s there’s a recommended retail price. And to the best of my knowledge, most of our competitors are selling at the recommended price. It doesn’t really like it, we’re just giving money away.
Kevin Lawrence 40:44
So what did he say? What did he say?
Brad Giles 40:47
You don’t understand Brad? And that’s always an interesting start to a conversation. Okay, then can you help me to understand? So that, if I sit dip into a side note of a side note, that’s the killer question for later, right. That is the killer question. So Kevin, can you help me understand why you didn’t come to work yesterday? Can you help me understand why our gross margins were any? Any whenever you want to be respectful and polite, and just cut through every single thing? Can you help me to understand this?
Kevin Lawrence 41:21
Exactly. coming from curiosity, it actually can be very disarming. And it is the right place to come from, versus accusatory or whatever else you want to do.
Brad Giles 41:32
But still directly addresses the issue anyway. So coming back, you don’t understand. And I said, Look, we’ve got to, I think that what we need to do is we need to say unless there’s a reason, that can be justified, you know, and lost. I don’t believe that lost leaders are actually really a reason I think it’s a it’s mostly it is evidence of a weak strategy. All right.
Kevin Lawrence 42:02
Yes, and by the way, on loss leaders and so what we’ve done in other companies, I starting off by discounting your price is usually not a good strategy, unless you’ve proven an ability to convert to higher pricing or something else. Some businesses do, like in the tech world and not but like in the software, they’ll suffer as a service and stuff.
Brad Giles 42:21
yeah, I get it. It’s a complex thing. Yeah, it is. But
Kevin Lawrence 42:25
generally, it’s a cop out. You know, it’s, strategic, or investing in this relates to you know, we’re doing companies now that want to do it. Awesome. You know, we’re giving up 10 grand for this strategic piece? Well, let’s allocate it, we’ll take it over the marketing budget, because that if it’s strategic, it’s actually marketing. Marketers gonna freak out and say no way. But if it’s truly strategic, let’s account for it properly, because marketing is where the strategic stuff would go. So anyway, go back.
Brad Giles 42:56
Yeah, that’s exactly what I’m saying. Because when you are discounting, your, you are taking money out of somewhere, because there’s a lifetime value to that customer. And it could be $1 million, or whatever it is, you’re just taking money out for no reason. And it’s, it’s because either they’re lazy, or they’re bad sales people. O
Kevin Lawrence 43:23
they could be making a good decision. But that’s really good to get run through the process and really dig in with your manager to understand it shouldn’t happen easily.
Brad Giles 43:39
No I can’t wear that. A good salesperson can sell ice to Eskimos, a good salesperson can sell at a higher gross margin. I know what you say, Yes.
Kevin Lawrence 43:53
doing a bit if you’re bidding on a project, and you’re gonna, you know, build a big building for someone, and you go in and you bid $22 million. And somebody else goes in there and bids 21. And the guy says, Look, if you guys come in at 21 and a half, you can have it. You got to say is, you know, for that 500 grand, which is about 5%. Maybe? No, we’re not. I mean, five ish, you know, is it worth it? Like there are scenarios where we’ll sit in meetings and decide, you know, we got to give up a little something, but we can get the business or your long term contracts. five year contract.
Brad Giles 44:38
I understand exactly what you’re saying a good
Kevin Lawrence 44:40
Brad right here because I hate discounting. Hate discounting. And I and I think it’s the key is it somebody taking the easy way out? Or is there a legitimate reason and you need to be in that to get the buzz now, if, depending on if you’re discounting all the time, then you got There are systematic problems. I agree. But I just think there are times when it’s like, you can justify it or rationalize it. Or it might be a good decision. It said differently. There’s different margins for different customers with different reasons.
Brad Giles 45:16
I’m gonna go back to your building example, I’m going to just Cornerstone by saying, You’re right. And sometimes it can be substantiated. but, it’s just that we give salespeople I’m, I’m so tough on it, because we give salespeople a license to be lazy. And I just don’t like doing that at all. If we go back to creating example, if that was, what if the sales person had built a relationship with that person for the last two years? Because it’s a $21 million building, right? They, this is not a transaction necessarily. And they built that and they demonstrated value, they’d understood all of the decision makers, they’d understood the decision making criteria, they, they demonstrated why they’re different than the competition, it’s just that we give salespeople I’m, I’m so tough on it, because we give salespeople a license to be lazy. And I just don’t like doing that at all. If we go back to creating example, if that was, what if the sales person had built a relationship with that person for the last two years? Because it’s a $21 million building, right? They, this is not a transaction necessarily. And they built that and they demonstrated value, they’d understood all of the decision makers, they’d understood the decision making criteria, they, they demonstrated why they’re different than the competition.
Kevin Lawrence 46:01
That’s why they’re given the heads up, drop your price by 500 grand, and you can have it.
Brad Giles 46:13
that’s why they got the heads up. And that’s why I’m saying you’re right, like, it’s not possible in every situation. But Jesus got to be a high bar discounting, there’s good for sure.
Kevin Lawrence 46:23
And I and Brad, Brad, I’m with you. 100%. Yeah, discounting should not be easy. And it’s like, we should be trying three or four other things before we discount. Yeah. Right. And, and, um, exactly, to hold our price and hold the integrity of our pricing, for example, you know, in the in a real estate development world, you know, if the market softens a little bit, they generally don’t discount, but they’ll add on if you extras and everything else totally revived the integrity for the price. So it is important, but the key thing with salespeople is, is that they are given the power to move on pricing, then there need to be controls in place, which smart organizations have. But they should also be paid based on that. And I’ve seen organizations, that your percentage of commission varies dramatically, depending on the gross margin you sell at. And if you sell it at 40, you’re going to get your full 10 points. If you sell it 35, you get you know, five points, you still have 30, you get one point I’m exaggerating. But the concept is, is that you notably feel an impact. And if you if you do a deal at 29 that would be a higher margin business. I’m like, you don’t get paid. But we’re, we’re thankful you get your base salary, because that doesn’t really add the right value to the business. And that’s it just you know, be careful that we’re being respectful of sales people and you know, it’s sales managers job to manage this process, right sales manager’s job to do the training, to be the backstop and the approval to get involved on the tricky deals. Because, you know, sometimes they’ll people don’t think they’re going to get the business. Some buyers are really smart. Hey, like some buyers know how to work a salesperson and get them thinking that they can’t get it in a funny line. A guy who went to college with his name, I don’t wanna say his name. His name was saverio he was a fun guy and Italian guy a character like you wouldn’t believe. And he used to sell used cars as the way he paid through school. And you know, when he was negotiating, and in the car business, when you buy the trade, you price the trade, that’s really it’s very important to price. They walk around the car, and he Oh, geez, look at that thing there and scratch What happened? Cheese, that’s a good dent you got there. And then he’d say, what do you want for the car? and Brad would say I want 10 grand, it was probably worth 10 grand once? Why is there a gold brick in the trunk? Like what? You know, you would have this reaction put the customer and he was a bit of a slippery guy. But the point of it is, is he was already setting up the negotiation so that you were probably going to get seven grand for your car. And, and kind of putting on your back foot. Because that was part of their their margin strategy is to buy trades at a price where they can easily make money on them, which is you know, there’s all kinds of tactics but you know, a good salesperson throwing the customer off their game. And there’s other examples where though the customer or the buyer, you know, can be really smart about this, and we’re not trying to say that to do no slip or use car sales tactics. It’s just it was always entertaining. And he made me laugh. Yeah, but, but the idea of it is is to really know where you make your money and keep an eye on it and be willing to walk in and there’s a whole other thing around negotiation. Yes, people are amateurs like negotiating with most people’s like taking candy from a baby. Like, they don’t understand the psychological principles both with customers. I’ve seen executives negotiate with the CEO and I’ll pull the CEO aside said, you just got worked. Like they put you in a psychological box before they did it. And then they did it. You didn’t even know what was going on. But they were getting pickpocketed in the middle of conversation. Yep. Because of the way they said there’s a whole other conversation we can have around negotiating. So we pull it back to the really the principles here, Brad that we’re talking about is, you know, we’re both so we’re so similar. It’s a different perspective. But I’m so passionate about gross margin, because as we both learned that makes a real difference in the number of things, pay attention to it. And understand the leavers of what, what’s going on. And then when you’re looking at new opportunities, whether it’s customers products or whatever, you should always be searching for higher margins, or kind of, you know, the top of the margins that people are able to achieve in a similar business. And you don’t see how you could do it, but learn from them.
Brad Giles 51:11
The right number and we’re moving to close, but in the right number creates the right question. Okay. So yes, by understanding that the purpose of the reason that we get numbers is so that it gets us to ask the right questions. And gross margin is the biggest producers the biggest questions with the biggest impact.
Kevin Lawrence 51:33
So one last story I have to share. And this is on the estimating or pricing piece. So I have a client that did a lot of volume in the manufacturing space, they were they many factor, they sold directly, and they sold through retailers like Amazon and the like. And they had a product that they would do. It was a few million units a year of and somebody on the pricing department screwed up the estimating side. They were losing $17 a unit. Wow. And they didn’t Wow. So $17 of lost of negative gross profit per unit and doing a few million units a year. That’s not a very long term strategy. No, thankfully, they made so much money on their other stuff. They were they were okay. But when it’s they started to see why they were losing profit they’ve dug in. Yeah. And so again, this is why this stuff needs to be double checked, you know, gross margin overall, by customer by product line, slicing and dicing it lots of ways the best way you can. rough numbers is okay. But there’s, there’s a lot to it, because it’s basically the money making engine of the business. And it’s worthy understanding. And if you want, the key is someone to produce the analysis and financials that comes from a packaged goods company, like a Procter and Gamble type business, so they live and die by this stuff. You know, someone who has a sophisticated reporting background, we’ve got one consultant that we use, that helps us with that for some of our clients. But it’s really got to have the numbers to know and for almost everyone on your team, when you have the numbers, and you set a target and you get their brains there, they can make it better. But without like we both you know, Brad, you in the red, yellow, green on the quotes, you know, my other client on the red, yellow, green on each of the projects. Yeah. It’s like, it helps the good people to make the right decisions and title you as a leader to make your business sustainably more profitable and stronger, too.
Brad Giles 53:49
Yeah. Awesome. What a good chat. Look, we are pretty passionate about it. Because you know, we just say that the returns that it creates. Good day today. So thank you very much for your time. Today, everyone. We are the growth whisperer as Kevin Lawrence and Brad Giles here talking about how to build an enduring, great business. If you’d like to learn more about myself, you can go to evolutionpartners.com.au and for Kevin, it’s Lawrenceandco.com. Thanks very much for your time. Have a great week.
Kevin Lawrence 54:27
Have a great week. Grow that gross margin.