How CFOs Improve Gross Margin (CPG Example)

What if I told you that by increasing your gross margin by 10 percentage points, you can dramatically increase the profitability of your business by using these levers: pricing, cost management, and mix optimization? Would you know how to do it? Well, that is the topic of today's video: how CFOs improve gross margin. If that sounds good to you, stick around and let's dive right in. All right, gang, let's go through an example. The company we have is a company in the C— CPG space, consumer packaged goods. This company creates a beverage in the form of a powder. So I'll show you what the product looks like. They create a powder that comes in a pouch like this. You open the pouch, you put it in a bottle of water, and you drink it, um, as a delicious hydrating beverage. Okay, so the company has right now revenue of $1,000, COGS $500, leaving it with a gross profit of $500. Which is a gross margin of 50%, which is okay for a CPG company. Typically, the gross margin for CPG ranges somewhere between 25% upward, 60%, 70%. Uh, that's different from SaaS companies where you can get to 80%, 90% gross margin, right? So for a CPG, this is pretty respectable, but our target is to get it to 60%. Why do we want to do that? For a number of reasons. The first one is more cash for growth. So as we keep money from the same customers and the same sales that we have, we can invest that money in the business in multiple areas. Where do businesses reinvest this cash usually? Well, it's going to be in hiring more salespeople so they can sell the product, spending more on marketing, spending more on the operation of the business. So customer support, AI tools, maybe to improve the customer support experience and things like that, right? So keeping more of your money that you're selling already for,, will help you in growth. The second thing is protection during downturn. So as the company entered into a recession or a time where consumers aren't spending as much and you aren't able to attract new customers, keeping more money from the customers you already sell to is going to help you weather the storm and withstand this downturn. The second area is going to be higher valuation. So if your company is a target of an acquisition by a private equity or another company, Uh, they usually look at two metrics in evaluating the price. So they'll assign a multiple of your revenue or EBITDA profit, and that multiple is going to be dependent on two things. First one is going to be gross margin. So gross margin is going to be a factor. The second thing is going to be your revenue growth. And I made a video on this topic I'm going to link up to here where I talk about the variation in revenue growth and profitability and how that impacts your valuation multiple. So that's why companies care a lot about gross margin and revenue growth. Okay, so these are the reasons why we should be doing this. So it is an effort worthwhile. Now, how do CFOs go about analyzing, uh, gross margin and coming up with an improvement? Let's talk about it. So in improving our gross margin, there are two elements that we pay attention to: revenue and COGS. We want to increase revenue and reduce our COGS. What are the elements or the levers that we have here that help us increase revenue? Well, that's going to be pricing and mix optimization, and we'll talk about this in detail with example. What are— what's here in the levers that's going to help us with COGS? Well, that's going to be the cost management, direct, direct material, direct labor, overhead, and freight-in. So let's talk about an example product. So we have here a CBG company that manufactures this delicious beverage that comes in the form of a powder. This box here is sold to consumers for $10. So the sale price is $10. Periodically, what you need to be doing is revisiting and reviewing the pricing that you have, looking at the competitive landscape, making sure that you are getting the price that you, that you command for your product. So if you're making a high quality product, you want to be charging appropriately for it. So as we review our pricing, we realize that we could be charging $10.50 on our website for this instead of $10. So we'll assume that we can increase that to $10.50. Uh, that's going to give us a boost in our revenue from $1,000 to $1,050. So let's put that in. We already are improving the formula here. So the pricing is going to matter. The second thing is gonna be discounts. So typically we run discount programs so that we can entice new customers to come in and try the product. And you wanna keep that going, right? You wanna attract new customers by offering discounts. But at some point you wanna look at that and make sure that you're reeling that in, you're not offering too much of a discounted product. Maybe instead of offering 50% discount, offer 30% or 20% discount and do some testing and experiments to see maybe that is the right point instead of a deep discount. So pricing and discount, that's gonna help us with the revenue piece. We'll skip cost management here for a second and look at mix optimization because that's gonna help us also with revenue. So with mix optimization, we have product mix, customer mix, and channel mix. With product, we'll imagine that we have maybe 3 or 4 products that we're selling. And by looking at each one of them, the gross margin for each one, We realize that product A, this product, is the high margin product. So naturally you're going to want to focus on that product and lessen your effort on your other products if that is what's making you the most money. So that is product mix. With customer mix, imagine that you are a B2B. So we're selling to Walmart and local grocery stores, our product here. With Walmart, maybe they are squeezing me more on the selling price. So I'm unable to charge higher price with Walmart. So I want to be promoting my product more at the local grocery stores where I'm able to sell my product at a higher price. So that is the customer mix. With the channel mix, a good example of that is if you're selling your product on your own website and also you're selling it on Amazon. Well, with Amazon, you want to keep that going because that's going to give you a huge exposure for your own marketing. But also keep in mind that with Amazon, you have to keep providing discounts to participate in Prime programs and other things that they run. So you're going to keep less of your money with them. So what you want to do is improve the experience on your own website. So maybe add customer tutorials, customer descriptions, and things that will enhance the experience on your website more than the experience on Amazon website. And gradually then you can increase your price on your own website compared to Amazon so that you can command higher revenue overall by improving that experience. So that is what we mean by channel mix. Now, let's go back to cost management here because this is pretty important. For our product, our cost is $5. If you remember, we said our revenue was $1,000, our COGS is $500, and we kept $500 in gross profit. So we have a cost of about $5. So we're going to look at the elements of that and reduce that cost. So what do we have? We have direct material. Direct material typically for a product like this is ingredients and packaging. So I want to be looking at my ingredients, what goes into my product, and the packaging. In my example here, the packaging can be improved. So what we have with my product is we have here a box inside of the main box that separates each flavor separately. So what I can do is I can do away with that box. So, um, instead I will put all the pouches inside here without this additional box inside of my main box. And the cost of this, when I cut this away, times maybe 6 or 7 or 8 that come inside of this box, um, if you consider at scale, each of these is like a penny. So that can maybe save me about 6 or 7 cents in the process. So we'll put that in as a reduction to our cost for packaging, about 7 cents that we are saving in here. With direct labor and overhead, we are using a co-packer, co-manufacturer. This is pretty typical in the US for a consumer packaged goods that is food-oriented, that you're using a co-packer, co-manufacturer. What it means is that instead of me creating my own factory, instead I go out and I find another manufacturer that already exists, and they will manufacture each unit for me and just charge me $5 for all of the ingredients, all of the packaging, and everything. All in, right? So with direct labor and overhead, I can look into my co-packer and look at maybe additional co-packers, and I can go and say, I want an RFQ, request for quote. Request for quote is, well, they will look at what you need and give you a quote, and that quote could be lower than what you pay now. Say you save here maybe 3 cents. So we saved 7 cents and 3 cents, and that's going to help us reduce our cost. So our COGS, instead of being $500, our COGS is going to be $400. And that will give me a gross profit of $650, which is about— when you divide that by revenue, that's about 61-62%, which is even better than the goal that I had. Another element in cost management is freight-in, the cost to bring in the shipments from your co-packer. Some ideas to reduce that cost is to consolidate. So instead of getting 3 to 5 shipments per month to your warehouse, maybe consolidate in one shipment. Another idea that I've seen happening is that you can then ship directly from the co-manufacturer directly to the consumer instead of having it come to your, your warehouse and then shipping it out to the consumer. So these are just some ideas how CFOs think about reducing the cost. So again, in summary, you can improve the profitability of the business and change it dramatically by increasing your gross margin. You can keep more for future growth. You can protect your business in a downturn. You can command a higher valuation with a higher gross margin. How do you improve gross margin? Well, you look at your pricing. Your pricing is going to be tied to your mix. That's going to be product mix, customer, and channel mix. And the way to reduce the COGS itself is to look at the elements that make up each product that you sell, direct material, direct labor, overhead, and freight in, and try to work on each one individually to reduce it. If you enjoyed today's video, don't forget to give it a big thumbs up and look below the video to see if you're subscribed to the channel, because if you're already here watching the video, it means that you value this content. And you want to be notified the next time I post a video. Hopefully you enjoyed this video, and I'll see you in the next one.