- June 15, 2015
Capstone of Success: The Impact of Gross Margins in Identifying Strengths and Eliminating Weaknesses
Although a principal goal of any business is to make money, it is vital for company leaders to keep in mind that increased revenues do not necessarily indicate comprehensive underlying financial strength. When CEOs become overly concerned with revenue generation, they probably do not focus enough attention on profit efficiency. By using a misguided approach, the total enterprise value is quietly compromised with every invoice generated.
A better long-term strategy for evaluation and planning would lead to more accurate current snapshots and a more valuable company later on—when it comes time to execute an exit strategy. Therefore, to avoid the silent value killer of declining margins, leaders should seek to implement a set of value-enhancing actions.
Six Solutions to Ensure Profitable Change
How does a company decision-maker change focus to enhance gross margins? There are several obstacles that stand in the way of progress, but they all involve a general resistance to change. In short, many involved stakeholders are reluctant to exit the collective comfort zone.
Clients do not want vendors to change and employees may even resist. Perhaps the leadership does not want to overhaul systems and protocols because the required additional work would appear to divert attention away from the short-term goals. To be successful, the CEO must completely understand the market and offer decisive guidance to restore margins and client value. This can be accomplished by carefully performing the following six steps:
- Define your company’s business goals
- Analyze clients by revenue and gross margin, evaluating the individual nature and bond of each of the relationships
- Understand your competition through meticulous market scrutiny
- Assess your internal structure, organization and compensation, keeping in mind that structure dictates behavior
- Align messaging, organizational structure and compensation
- Deliver high quality work
It might appear that the whole business would need to come to a near standstill to carry out such solutions, but in truth, increased efficiency leads to greater profits, and not solely in the distant future. On the personnel front, engaged employees seek challenge, streamlining, and education, and would welcome new and better techniques and philosophies to better do their jobs. In truth, the performance of these steps is not actually a choice. If leaders do not pay close attention to what the market communicates, and remain vigilant in avoiding the bona fide risks of commoditization and of the subsequent real costs of inaction, then eventually the ever-dwindling margins will have a deleterious effect on the daily operations of the company.
Risk of Commoditization
When leaders continue to rely on the “business as usual” approach, the unique relationships once enjoyed with clients could slowly and insidiously transform, leaving them looked upon as just another replaceable company. The following is an example of a once-successful company that over time lost focus, margin and revenue, in that order.
Company A is a large enterprise that has been doing business with your firm for five years. Your headcount with Company A has grown from zero to 50 billable professionals. You naturally desire more work and profit opportunities from the client, so you dedicate more resources to meet these objectives. But during this growth period, your contractors (who began with the client five years ago) want more money each year, so your annual costs are rising. Of course, the leadership of Company A does not want to face rate increases every year; in fact, they seek rate decreases. Additionally, when the relationship began, you could meet directly with key managers to sort out challenges in mutually beneficial ways. You enjoyed a strong collaborative relationship with active participation on both sides. Now you feel as though you are no longer welcome. You have become just another supplier, and perhaps even a higher-cost supplier. You have become commoditized.
Because the CEO falsely believes the business is doing well, that individual may believe the company is providing a value to the client by reducing prices. But, in fact, the CEO is doing very little to increase the value of services. There is more to value than simply billable rates. While being commoditized, the CEO’s business structure rewards business development—or new revenue, which means higher costs due to commission. Because the CEO did not correctly set rewards to encourage higher-margin clients, a perfect storm that will devalue the business is forming on the horizon.
The Real Cost of Failing to Adapt
When a business gets commoditized, change must come quickly and comprehensively to rebuild and find high-margin client relationships. Without these changes, the company and owner will work harder only for less and less value. This idea is best expressed in financial terms.
Prior to commoditization, the same Company A had revenue of $10 million with a 30 percent gross margin and was producing 10 percent EBITDA (earnings before interest, taxes, depreciation, and amortization). As a point of reference, assume the industry multiple range was five to seven times the trailing 12-month EBITDA. Since the company backlog was strong, and overall had healthy gross margins, the company could expect closer to a 7X multiple trailing EBITDA. At that point, Company A could have expected a selling price of approximately $7 million.
Two years later after commoditization, here is the updated snapshot: revenue is $15 million, gross margin is 20 percent, and EBITDA stands at 5 percent. Backlog is flat with a backlog gross margin also at 20 percent. Using the same industry multiple of five to seven times the trailing 12 month EBITDA, the same company would now earn a 5X multiple and be valued at about $3.74 million. Company A has increased revenue by 50 percent but has lost almost 50 percent of its value at the same time. The real cost of the failure to adapt is about $3.26 million.
Unfortunately, this happens in many privately held businesses. The root reason is because the leadership focused on revenue, not gross margin.
Key Learning Point
Gross margin is the lifeblood of every business, as it indicates the gross profit a company makes by selling their goods and services. Simply put, it is revenue minus the cost of goods used and hours spent to produce that revenue. Unfortunately, the necessary sharp focus on gross margin is blurred because most companies are afraid to shift their business away from legacy methods, structures, and clients.
CEOs are left pondering some very unsettling questions: Do you want to sell your business in distress? Do you want to sell to liquidators? Do you want to sell to your estate upon death?
The starting point to getting back on track is answering a very different question: How do you enhance the value of your business? Your focus should be on gross margin. By analyzing and seeking out the sources of high gross margin business, you will achieve positive results that will enhance the company’s value.