Maintaining (and increasing) gross profit margins
It’s hard to underscore enough the importance of maintaining consistency with your Gross Profit Margins (GPMs) over a period of years. In every deal we are involved in, the acquirer looks at the consistency of GPMs as an indicator of the health of the business. And well they should. GPM consistency shows, among other things, that you have disciplined cost controls and are adding value to the products and services you provide to your customers.
To look at this from the acquirer’s perspective, consider this example. If three years ago you had a GPM of 30%, and then it dropped to 27% the following year, and ticked back up to 28% in the current year, that would be perceived not exactly as erratic, but as a variance you should have taken more steps to control.
For ease of math, let’s say you have a multi-location business that is booking $100 million in total “topline” revenue. If your GPM is 30%, then $30 million is your gross profit. Let’s also say that you lost control of some of your cost of goods expenses. For example, you put a pay increase in place to keep key employees, or you had to lower the price of certain items to be competitive. Any time you have an expenditure that affects GPMs, and every product purchase expenditure does, you have to generate higher margin sales and/or adjust your Cost of Goods Sold (COGS), to maintain or improve your GPMs.
Don’t feel defensive if your GPMs go down, when you desire to have them go up. It’s easy to lose sight of GPMs if you are not monitoring them constantly, and it’s easy to have expenses creep up on you.
But from an acquirer’s perspective, slippage in GPMs is viewed as you essentially leaving money on the table. Here’s why. If you have a 30% GPM on $100 million in sales, you’re booking $30 million gross margin with your existing company infrastructure (product mix, staff, pricing systems, inventory, etc.). If you slip to 27%, then your gross profit drops to $27 million. That’s $3 million less than the previous year, yet you were delivering essentially the same service with the same staff. An acquirer will look at that $3 million as money that you could have realized with more aggressive cost or pricing management.
Let’s say your GPMs go up from 27% to 28%, yet were at 30% two years ago. From an acquirer’s point of view, that 1% increase (year-over-year, from 27% to 28%) will not be viewed as a raging success, even though you increased gross profit by $1 million; instead, the acquirer will likely ask why you can’t get back to and maintain the 30% gross margin you had two years earlier.
Now, let’s say that you have a three-year track record of increasing GPMs each year for the past three or four years. Now that’s progress!
If your business climbs from 27%, to 28% to 29% to 30%, you are obviously controlling your COGS, and improving the selling margin of your product mix. You may have added higher-margin products to your mix instead of selling commodity lumber, and maybe you took on more single-family customers, as opposed to multi-family, because single-family is higher margin. In this scenario, for a $100 million operation, your gross profit climbed from $27 million to $30 million, as you were able to wring out purchasing inefficiencies, increased direct labor productivity, took advantage of prepay discounts, and optimized your product/customer mix, yet still deliver the quality products and services to your customer base.
Now here’s the example that really put a cherry on top. Let’s say that the GPMs for your business climb from 27%, to 28% to 29% to 30%, and your revenue is climbing as well, say, from $100 million to $108 million over this period of time. Acquirers will swoon over a company that shows year-over-year sales growth and improved GPMs. It shows you’re growth-focused and disciplined over costs of goods and pricing; and that you’ve optimized the blend of customers with a bias toward higher-margin sales. That’s a business that will get the highest value in any economy.
LBM columns in book form: I’ve gathered my LBM Journal columns (and other writing as well) in my latest book: “M&A Basics for People in a Hurry: Key Deal Elements and Common Practices of Mergers and Acquisitions”. It’s on Kindle for 99¢, and on Amazon as a printed book for $7.77.