Gross profit margin is the percentage of your company's revenue that converts to gross profit. It is a key measure of profitability for a business. Gross margin is the difference between revenue and costs of goods sold, which equals gross profit, divided by revenue. Therefore, declines in margin generally occur because of shrinking revenue relative to sales volume or higher COGS.
If your revenue declines because of lower sales volume, it doesn't necessarily affect your gross margin. However, if declining revenue results from lower price points on sales, gross margin typically declines. A number of factors cause a business to lower prices and, subsequently, to experience reduced gross margin. They include:
- Excess Inventory Discounts: When you order too much inventory relative to demand, you normally have to discount remaining inventory to generate revenue and cash flow. Markdowns mean lower prices per unit.
- Increased Competition: If more competitors enter the market with substitute products, you may have to lower your regular price points on items to maintain or grow your customer business.
- Customer Base Objectives: In some cases, companies lower price points for a while as part of an aggressive goal of building a customer base. This goal may cause temporary declines in gross margin, with the aim of raising prices after the target is reached.
For a manufacturer, COGS includes such things as materials costs, per-unit product costs and direct labor expenses. For a reseller, COGS includes such elements as product acquisition costs, shipping fees and packaging. As costs go up for a manufacturer, they typically impact the producer and the reseller. If a manufacturer has to pay higher rates to its materials suppliers, for instance, it either suffers reduced gross margin or passes on the highest costs to the reseller.
In addition to potentially taking on the added costs from manufacturers, resellers often have to cover increases in shipping fees from transportation providers. Materials using in packaging may also rise over time.
Declining gross margins are problematic because they signal a reduction in profitability. If a company doesn't achieve strong gross profit, it is difficult to generate operating profit and bottom-line net profit. Stabilizing inventory buying to minimize price discounts is one strategy to combat declining margins. Better marketing and branding can also boost the customer's perception of worth when buying products. On the cost side, negotiating firmly with suppliers and seeking lower-cost options when rates spike are strategies to protect margins.