The first and most obvious thing to look at is the product prices. Have they increased dramatically from the prior year? This is often the cause of the increased cost of goods sold percentage.
Here are some steps to consider if increases in product costs turn out to be the problem:
- Get bids from other suppliers.
- Call your current vendors, tell them you're shopping around, and push for a price reduction.
- Look into price breaks for larger orders and other special pricing your vendors may offer.
- Consider passing the price increase on to the customer. Plan this carefully if your main selling point is having a lower price. Otherwise, you might be surprised at how much elasticity you may have in your pricing.
The problem is often a change in the products you are selling. To discover if this is the case you must know your product costs by product, not just a total. Get your accountant to put all your products on a spreadsheet similar to the one I review in the attached video.
It illustrates a rather simple (and extreme) example where the units sold and the total sales dollars are the same. But the product costs are dramatically different. If I sell the same number of units but sell more of the ones with the higher cost, the gross profit decreases from $4,800 to $3,400. This is even with the same sales amount!
The quickest way to fix a reduction in gross profit caused by a change in product mix is to use the 80/20 rule.
This rule is a useful guide for making decisions in the product management area. Indeed, you’ll find this works just as well in other aspects of your business operation. Let me explain what the 80/20 rule is.
80 percent of the products in your line bring in only 20 percent of the company’s sales, and, 20 percent of the items produce about 80 percent of the firm’s revenues.
Always monitor your product line. Shortly after the close of each year, prepare your product-sales data with the following data: 1) units sold, 2) sales dollars per product, 3) cost of goods sold per product, and 4) the gross profit per product.
Sort these lists from the best sellers to the worst. Then red flag and evaluate the lowest 20 percent on each list. Before deciding to drop an item from your line, ask questions such as:
Why is this product performing so poorly?
Was it priced too high? Too low?
Were its sales cannibalized by some competitive item in our line?
Could we have sold more if we had promoted it differently?
Is the item in the decline stage of its product life cycle?
Can we redesign the product to make it more salable?
Is there an untapped market for the product?
Is this product required as an add-on to a high profit item?
After due deliberation, start building a list of the items to drop from your product line.
Finally, concentrate on promoting your most profitable products. I have worked with several companies that have done the hard work outlined in this article. Without fail, they experienced a dramatic increase in profits.