Reasons for Gross Margin to Be Down
A company's gross margin is the percentage of its revenue that is converted to gross profit. It is calculated by dividing your gross profit amount by your revenue during a given period. For example, if your gross profit is $100,000 and your revenue is $500,000, your gross margin equals 20 percent. A gross margin that declines over time is cause for concern and should be analyzed.
Gross profit equals revenue minus cost of goods sold, or COGS. COGS includes only those costs directly associated with goods sold. For a manufacturing company, they include the costs of raw materials used in production as well as variable labor and production costs. For resellers, they include costs of product acquisition and packaging for resale. Increases in these costs with no change in your sale price diminishes your margin on each unit sold. A supplier charging higher materials costs to manufacturers because of shortages, or a manufacturer charging higher prices to resellers, would increase COGS for their buyers.
If your industry or company experiences a slump in customer demand, you might have to discount prices to generate sales for a given period. Discounted sale prices reduce the amount of revenue you generate without necessarily affecting COGS. This means you are making less gross profit on each unit sale. One way to combat this problem is to improve your marketing and sales efforts, increase demand for underperforming products, and return to normal price structures.
If your industry experiences greater competition, gross margins tend to fall across the industry. Suppliers have more buyers to sell to, which allows them to raise prices. Simultaneously, your industry's customers have more options, which often leads to across-the-board reduction in prices as companies compete more intensely for customers. Higher costs and lower prices squeeze margins.
Falling gross margins can also result from lost, stolen or damaged goods, which add to your COGS but don't generate revenue. These factors, collectively known as shrinkage, can cut into your company's gross profit. Managers must be diligent in keeping shrinkage to a minimum. When you pay for materials, or pay to acquire products that never generate revenue, you effectively throw away money. Inventory control processes and strong marketing and sales can help minimize this problem