You know gross margin impacts your profit, but have you considered the impact it has on the value of your company?
When assessing your company’s value, acquirers and investors often look at your gross profit margin. Gross profit margin is the difference between a company’s revenue and its cost of goods sold. In other words, it’s the profit a company makes from each unit of product or service sold after accounting for the cost of producing or delivering that unit but does not include other fixed expenses. For example, if a company sells a product for $100, and it costs $70 to produce and deliver it, the gross profit margin would be $30, or 30%.
A high gross profit margin is a crucial factor for investors and potential acquirers as it indicates that a company has established pricing power through marketing differentiation or production efficiencies.. Favorable gross profit serves as a strong competitive advantage improving a company’s long-term sustainability, making it more appealing to potential investors.
When a company’s gross margin shrinks, it indicates to investors that the company may be competing on price. This is typically a sign that the business lacks a unique value proposition or marketing differentiation and that competing on price is the only way to attract customers. Thin or shrinking gross margin leaves the company vulnerable to competitive threats and makes it less appealing to potential acquirers.
Managing Labor and Cost of Goods Sold
Gross profit measures how well a company generates profit from its labor and direct materials. Understanding the impact of labor on gross profit margin is important. Some types of labor costs are included in the cost of goods sold, while others are not. Only direct labor, involved in manufacturing a company’s goods, is included in the cost of goods sold or cost of services and ultimately gross profit.
Likewise, understanding material costs and anticipating supply chain issues that will impact these costs is also very important. Overhead costs are not included in gross profit, except possibly overhead that’s directly tied to production. It is important for companies to identify and secure the most cost-effective and reliable sources of raw materials.
Benefits of Knowing Gross Profit Margin
The benefits of knowing your gross profit margin include being aware of where to cut costs, where the business’s core strengths are, and positioning your business if you want to sell. Serious buyers will conduct thorough due diligence and dive into the financial profile of a company and all its expense lines to get a detailed cost of goods sold and the business value. Shareholders need to know what they are going to discover before the buyer discovers it!
To illustrate the impact of gross margin on a company’s value, let’s compare two companies: Apple and Dell. Apple has a strong competitive advantage and a healthy gross margin, whereas Dell’s competitive position is weaker, and its gross margin is lower. In 2022 Apple’s average gross margin was 43%, compared to just 23% for Dell.
Apple has a highly differentiated brand and controls the buying experience through its Apple Stores. Additionally, Apple has invested in a range of high-margin subscription offerings, such as Apple TV and Apple Music. The market is willing to pay more than twenty-four times Apple’s 2023 earnings forecast, and the company has a market capitalization of over $2 trillion.
By contrast, Dell offers commoditized technology products, which puts them in a weaker competitive position, requiring them to compete on price and resulting in a lower gross margin. The market is only paying around six times Dell’s 2023 earnings estimates, giving it a total market capitalization of around $30 billion.
Improving Gross Margin Without Cutting Costs
Reducing input costs will improve the gross profit margin but it might risk product quality. An often-overlooked approach to improving gross margin is to create a point of differentiation for your business in the minds of your customers. When your customers see your business as unique, you are less likely to have to compete solely on price. Charge a premium for a differentiated product or service, and you’ll beef up your gross profit margin—and the value of your company.
As owners consider selling their businesses, they must completely understand their gross profit margins and all the critical elements that drive this metric. While reducing costs through supply chain or production efficiencies is important, creating differentiating value can also improve gross profit margin without risking product quality.