Your Profit Margin Is Falling. Do You Know Why?

A declining profit margin is easy to see.
Understanding why is usually much harder.
Your management accounts might tell you that gross profit margin has fallen from 35% to 30%.
That's useful information.
But it doesn't tell you why and what to do about it.
Was it caused by higher input costs? Did your selling prices fail to keep pace with those increases?
Has the mix of products or customers changed?
Are you using more overtime?
Has productivity fallen?
Are you experiencing more waste or rework?
Or are you simply doing more business at lower margins?

The financial result tells you what went wrong.
Understanding the business tells you why.

 Not All Revenue Is Equal

One of the easiest traps to fall into is assuming that more revenue must be good for the business.
It isn't always.
Imagine two products.
Product A generates R5 million in revenue at a healthy margin.
Product B generates R8 million in revenue but requires more labour, more management time, more stock holding and considerably more rework.
Which one is really contributing more to the business?
The answer isn't necessarily the one with the higher turnover.
The same applies to customers.
A large customer may look attractive when you look at revenue alone.
But what happens when you consider the discounts they receive, extended payment terms, special deliveries, small production runs and the amount of management time required to service the account?

Sometimes your biggest customer isn't your best customer.
And sometimes your fastest-growing product isn't your most profitable one.

 Average Margins Can Hide the Problem

Looking at gross profit for the business as a whole can also be misleading.
Suppose your overall gross margin is 30%.
That number might look reasonable.
But underneath it you could have one division earning 45%, another earning 25% and a third barely breaking even.
The average doesn't tell you that.
The same problem arises when costs are allocated incorrectly.

Looking beyond gross margin, the way shared overheads are allocated can also distort divisional profitability.
I once worked with a business where overheads were being allocated between divisions largely according to revenue.
On the surface, that seemed reasonable.
But the division generating the highest revenue was absorbing almost 60% of the overhead costs, despite occupying less space and employing fewer people than the other divisions.
When we changed the allocation methodology to better reflect how resources were actually being used, the profitability picture changed.
The numbers hadn't been wrong.

The way we were looking at them was.
And that matters.
Because management decisions based on the wrong information can be worse than having no information at all.

Sometimes the Margin Problem Is Operational
When margins decline, the natural reaction is often to look at pricing.
Sometimes that's exactly where you should look.
But not always.
A manufacturing business experiencing margin pressure might actually have a production problem.
More overtime.
Lower output per labour hour.
Higher scrap.
More rework.
Poor production scheduling.
Machines standing idle.
Excessive material waste.
None of those problems begin in the finance department.
But eventually, every one of them appears in the financial results.
This is why simply telling management that margins have declined isn't enough.
The next question has to be: Why?

 Look Beyond the Income Statement
Good management information should allow you to move from the financial result into the underlying business drivers.
If gross margin is falling, you might need to look at:

• margin by product, customer or division;

• selling-price movements against input-cost movements;

• labour cost and overtime;

• material usage, waste and rework;

• production volumes and productivity;

• customer and product mix; and

• discounts, rebates and other costs of servicing customers.

You don't necessarily need more reports.
You need the right information.
And sometimes that information won't come from the accounting system at all.
It might come from your production system, your sales team, your warehouse or simply spending time understanding what is actually happening on the floor.

 Don't Stop at the Number
Financial information is valuable because it tells you something has changed.
But that’s where the investigation starts, not where it ends.
If your margin has fallen from 35% to 30%, knowing that number is important.
Knowing why it happened is what allows you to do something about it.
And the answer may be pricing.
Or procurement.
Or production.
Or customers.
Or people.
Or processes.
Or a combination of all of them.

 So here's the question I'd challenge you to ask:

If your profit margin fell by five percentage points next month, would your management information tell you why?

 If the answer is no, perhaps it's worth looking beyond the numbers.

 Better Decisions. Better People. Better Performance.