Not all Gross Margins are Created Equal

Originally published on LinkedIn Jul 11, 2021

Will the real gross margin please stand up!

Emerging CPG Brand founders are obsessed with Gross Margin %. That is the way it should be. The higher the gross margin the higher the ability to cover marketing and other fixed expenses and the shorter the timeline to get to EBITDA-positive. This can take three to four years. Many brands, unfortunately, never get there.

In conferences, webinars, podcasts you will often hear from industry veterans, investors and founders who discuss how your gross margins need to be north of 35% and 40% to even survive (depending on the category). At 45% or 50%, they contend, you really have a great shot at success! For many Emerging CPG Brands who are starting out, even achieving 30% initially is difficult. Achieving scale is necessary but also very expensive, if you consider the amount of marketing dollars needed to consistently stand out from all the clutter. Gross Margins are an obvious holy grail, but is it as simple as that?

When I first entered the Emerging CPG Brand space, I struggled with ascertaining the gross margin range that was appropriate for the various categories within which I was operating. As I engaged with various entrepreneurs, distributors, retailers and financial experts, I found that most of them always reverted to the often-quoted "industry-norm" range that they had in mind.

What I soon discovered, however, was that when you drilled into the detail, there were great variations or differences in how those gross margins were calculated! Even within the same category. One brand's 40% Gross Margin % was not the same as another brand's 40% Gross Margin. Founders, investors, distributors would have conversations and perceptions about a common gross margin number without realizing that in many cases that the their frame of reference was different.

A good deviled egg is in the detail

Over a month ago I participated in a well-attended webinar for Emerging CPG Brands where the presenter shared ambiguous and sometimes misleading guidance on calculating wholesale pricing, and gross margins. The presenter's guidance on how trade spend is handled and what is included or excluded in COGS was also somewhat inaccurate. This is unfortunate as it is likely that some aspiring entrepreneurs are going to use the guidance given in that webinar to draw, what I believe are, incorrect conclusions for their emerging brands.

Misconceptions on how gross margins and sales contribution margins are calculated are quite prevalent and can lead to poor and sub-optimal, marketing, operational and financial decisions.

When discussing gross margins, the astute CPG stalwarts and CPG-focused investors/bankers will always ask you the following two questions:

Is your Gross Margin % a percentage of Gross Sales or Net Sales?
Does your Gross Margin % take into account Trade Marketing Expenses?

The answer to these two simple questions forms the basis of how gross margins should or should not be calculated.

Firstly, it is recommended that Gross Margin % should be measured as a % of Net Sales to Distributor or Retailer (if selling direct). This approach is in line with Generally Accepted Accounting Principles (GAAP).
Secondly, most Trade Marketing Expenses should be subtracted from Gross Sales to get to Net Sales — Not just the payment discount or other standard items such as excise or other taxes.

I stated "most" trade marketing expenses, because it might be quite appropriate for certain Trade Marketing Expenses to be part of Selling Expenses for certain companies and certain categories.

(A shout-out must go to Bob Burke of Natural Products Consulting, Andy Whitman of Loft Growth Partners, and Michael Burgmaier of Whipstitch Capital who over many years have always advocated for the correct way of allocating trade marketing expenses and measuring gross margins. Their thoughts and advocacy helped correct and re-shape my own approach at the time!)

How you allocate Trade Marketing Spend matters. A Lot!

It is not uncommon for sales teams or Emerging CPG Brand founders to omit the inclusion of Trade Marketing Expenses (also known as trade spend) when calculating pricing and margins. The proverbial use of the quick back-of-the-envelope calculation for brand-owner margins when calculating a price-to-distributor or retailer is rife — and often incorrect, if trade marketing expenses are not taken into account.

Given that in many categories, it is almost impossible to build a brand in bricks 'n mortar retail outlets without any Trade Marketing Expenses, it still surprises me how often it is not taken into account.

Deals are proudly made with the expectation of achieving an acceptable Gross Margin. It is only later, once placement is achieved, that brands have to face an ongoing shock and awe barrage when all the discount and promotional deductions come through.

As you increase distribution, the wise use of Trade Marketing dollars might be "all you have" at your disposal — that, in conjunction with some smart digital marketing approaches can be used to keep your brand front and center at retail. If you want to grow and scale you are going to have to invest!

The numbers don't lie. Ok, maybe sometimes.

The best way to visualize the impact of different approaches to measuring Gross Margin %, is by way of example. Let's consider four scenarios. For all four scenarios, let's assume that:

We sell our emerging brand to the distributor at a gross sales price of $120 per case, so that the distributor and retailer can achieve their own target gross margins for the suggested retail price targeted at shelf.
Trade Marketing Expenses are budgeted for a total of $20 per case.
Direct Sales Expenses such as broker fees and outbound freight costs amount to $20 per case. (Note that outbound freight to distributor or retail warehouses is added to Direct Sales Expenses and not COGS)

Scenario #1: Allocating Trade Marketing incorrectly + GM% of Gross Sales

For Scenario #1, Trade Marketing Expenses are allocated "below" the Gross Margin (GM) line. Assume also, that your co-packer is charging you $78 per case which includes material, their labor and their margin.

In this scenario, your resultant Gross Margin amounts to 35% of both Gross Sales and also of Net Sales, given that Trade Marketing Expenses are allocated elsewhere. You can see that you are not generating enough Sales Contribution to cover your overheads, but the COGS of $78 per case that yields a Gross Margin percentage of 35% might seem reasonable. It is still early days after all, and you believe that you will eventually get to scale and be able to benefit from longer co-packer runs and therefore lower COGS prices. Or so you lead yourself to believe.

Scenario #2A: Negotiating lower COGS to get to 40% GM% of Gross Sales

You have now started talking to investors, and the pressure is mounting to show a gross margin % that is "at least 40%" for the forthcoming year. You reformulate and accept that you will have to hold more inventory to get to the co-packer's volume threshold that will result in a COGS of $72 per case. All is good, but why are you still struggling to pay for overheads? (Note: When Sales Contribution = Overheads...you get to EBITDA zero)

The point here is that for as long as you ignore or misallocate Trade Marketing Expenses so that you are only using Gross Margin % as a percentage of Gross Sales, you will continue to get a false sense of comfort with your "40%" gross margin achievement.

Scenario #2B: COGS of $72 per case. But measuring GM% correctly

In this scenario you correctly allocate the $20 per case of Trade Marketing Dollars to get to Net Sales. You still have the same Sales Contribution in Scenario #2A and Scenario #2B.

If, however, you look at Gross Margin % of Net Sales (and even as a % Gross Sales), you now have a different perspective of the brand's performance. You thought you were achieving a gross margin of 40%, with the renegotiated co-packer arrangement, but in fact your real gross margin as a percentage of net sales is 28%! That is quite a difference!

Scenario #3: What should my COGS be to achieve a 40% GM of Net Sales?

In many categories, to have a shot of being successful, an Emerging CPG Brand will need to start achieving a Sales Contribution percentage of net sales that moves towards the high teens and 20's. And, to achieve a gross margin as a percentage of net sales that is at least 40%, your brand will need to target (for this scenario example) a COGS of $60 per case. That is very different per case cost than the one you negotiated for $72!

In these fairly simple scenario examples we can see that an incorrect allocation and gross margin measurement approach can give you a false sense of comfort. It can lead you to take sub-optimal decisions. Would you even have entertained launching that SKU if $60 COGS per case is unlikely to ever be achieved? Would it have made a difference if you had set a different Suggested Retail Price that would still allow the brand to resonate with the consumer, but that would allow you to set a higher Price-to Distributor?

Why is this a BFD?

Incorrectly calculating your Gross Margin % can lead to a situation where you might believe that your gross margin % is sufficiently acceptable in order for you to set and accept a certain wholesale price to distributors or to retailers if selling direct. Once you have set your wholesale pricing level with distributors and retailers, it is always difficult to change. Especially, if you do not have the necessary brand power and velocities that would make you highly valuable to those distributors and retailers.

The biggest risk that I see with regards to omitting or misallocating Trade Marketing Expenses and not measuring Gross Margin as a percentage of Net Sales is the "warm-feeling acceptance" that your current COGS is "ok". This can unrealistically lead you to believe that it will significantly and "naturally" reduce as you sell more and get better co-packer or capacity utilization rates! This is not to say that you should walk away from that brand or SKU. Knowing the real numbers gives you the opportunity to assess and test whether your brand is compelling enough to demand a higher price-point, whether you can reformulate without losing taste and functionality, and whether you need to aggressively target COGS reduction and purchasing initiatives.

When discussing gross margin percentages with potential investors, and further down the road with potential acquirers, it is important that all parties are using the same frame of reference. The astute investors and most CPG strategics and acquirers will likely restate the gross margins if they are incorrect. This could potentially influence discussions and even the outlooks on investment feasibility, valuations and ultimate acquisition.

There is an argument that an industry or category eventually converges to fairly consistent margins for particular products and categories. In the past, this was mostly true as Suggested Retail Price points remained stagnant and as mainstream categories commoditized. Within the last 12 years however, there has been a remarkable growth in better-for you natural brands that meet the needs of better-informed and more demanding consumers. These brands came in at higher price-points but also with higher COGS.

The ongoing shift to functional foods and beverages will continue to pressurize margins given the higher content quantity and quality of the ingredients. Large CPG players are rushing into this space and they are using their scale to suppress pricing at the shelf and are leveraging their supply-chain power to reduce COGS. For Emerging CPG Brand founders, knowing your true margins and COGS is a good place to start planning a pragmatic and measured growth plan if you want to out-execute your well-funded and resourced competitors!