We should be grateful that accountants invented the concept of gross margin.
The simple formula — revenue minus cost divided by revenue — really becomes valuable once we get past the arithmetic and view it as the extra value seen by a customer over a product’s manufacturing cost. This extra value can be a result of superior technology or service or lower costs of manufacturing from better business processes or procurement.
Customers determine price. Their buying decisions set the price and assess this value. However, shareholders set the gross margin. Those who buy or hold stocks bias a company’s valuation through a correlation with gross margin. Therefore with customers determining price and shareholders setting gross margin expectations, the supplier is left controlling the company’s costs and its superior technology or service enhancement differentiation.
For a company to be successful in the long term, it must be the low-cost provider of the products or service in the market it chooses to be in. There are two reasons for this: The first is that companies need high gross margin dollars to fund the development of a differentiating technology or service. Second, technology and service differentiation is fleeting; sooner or later a company will find itself in a battle on price. It had better be ready with low costs when that day comes.
How does a company know if it is the low-cost producer, and, if it is not, how does it determine its gaps and leverage points for improving its cost position? Benchmarking is one good approach. Companies can benchmark their business processes and overheads as well as transformation and materials costs. If a company determines it is not the low-cost producer it must take steps to improve.
Another action that can be taken is to ensure that the company does not suffer unnecessary costs from poor security of supply, for instance, due to single-source issues or unexpected end-of-life surprises. When these unnecessary realities occur, overhead costs rise significantly.
The gross margin equation plays out every day, over and over again, as competitors enter the market with innovative new products that disrupt the status quo. The best companies keep tight control on costs in good and bad times and always know their value and competitive position.