We were reminded of this over the last few days as we had several discussions about corporate growth.
One was with the publisher of a newspaper who was talking about an event they were holding for the “Fastest Growing Companies” in the area.
Another was with a company that was having a bit of financial difficulty but was talking about coming out of it due to recent growth. In fact, their plant was now so busy they were planning a second shift. They were sure that this growth would resolve most, if not all of their financial issues.
When we initially started the receivership, management of
the company wanted to know why we were there.
This led to thinking about a recent assignment that Revitalization Partners just completed. When we initially started the receivership, management of the company wanted to know why we were there. After all, revenue had been growing substantially and they were winning most of their competitive bids. That was the good news. The bad news was that they were losing money at an increasing rate. While expenses were a bit out of line, it wasn’t bad enough to account for the increasing loss. Besides, the company had been highly profitable a year ago with expenses levels that were almost as high.
In order to understand what happened here and to understand why growth may not be the answer and in fact, may even be the cause of the problem, we need to understand a term called Gross Margin.
Investopedia explains Gross Margin as: The number representing the proportion of each dollar of revenue that the company retains as gross profit after incurring the direct costs associated with producing the goods and services.
For example, if a company’s gross margin for the most recent quarter was 35%, it would retain $0.35 from each dollar of revenue generated, to be put towards paying off selling, general and administrative expenses, interest expenses and distributions to shareholders.
In the case of our client company, prices
were dropping in their industry very rapidly
In the case of our client company, prices were dropping in their industry very rapidly. And, as a large distributor, they were holding a lot of inventory, some of it for several months. Because of the rapid price drops, the inventory was devaluing as it sat in the warehouse.
Because they had bought the inventory when prices were higher and sold it when prices were lower, the gross margin on the sales was continually lower than expected. And since Gross Margin is the money left over to pay expenses, those expenses would have had to continually drop for the company to remain profitable.
In the case of the company planning the second shift, they have to consider the overhead cost of that second shift.
- Are the second shift employee’s full time?
- Do they have benefits and associated overhead?
- Is additional management needed?
- And, how much Gross Margin is generated on that second shift at the outset to pay for the expenses?
It may be there is actually a cost and a negative impact on the profitability of the company until that second shift reaches critical mass in Gross margin generated. And, given the financial difficulty of the company, can they afford it?
Lastly, one of the companies on the list of Fastest Growing Companies went from Number 1 in 2010 to Number 11 in 2012. It was placed into receivership by its bank in 2013. While that revenue growth may have been exciting and award winning, it clearly did not lead to a long term successful company.
Understanding the importance of gross margin
and keeping it constantly in focus might well be viewed
as a simple key to business success.
Understanding the importance of gross margin and keeping it constantly in focus might well be viewed as a simple key to business success. But viewing revenue growth for its own sake in the hope that will somehow result in success should be considered as simplistic. It would be nice as we celebrated our “Fastest Growing Companies” to focus on both the top AND the bottom lines. But, it’s clearly not as simple.