The Impact of Cost Drivers on Gross Margins

Sep 28, 2015

Last week I was reviewing the financials of a manufacturing company when I noticed some interesting details. Based on their data, the company had minimal debt, high equity, and very good cash flow. You are probably wondering why is this so interesting? Well, if I stopped here, I would agree. However, the interesting part was the gross margin which was around 14%! Overall profit wasn’t too bad but was not as high as one would expect with that kind of a balance sheet. What are some reasons gross margin could be so low? What would you expect the margin to be?

I would expect the gross margin to be at least 20%, if not more. So why is this not the case?

• Overhead too high
• Too much direct labor
• Poor material quality
• Faulty machines

All of these reasons can dramatically impact gross margins. However, I believe the negative impact can be attributed to inaccurate costing information. When a company is unaware of its costs, critical decisions are made based on inaccurate information.

This company has been in business for over 100 years. At one time, the cost driver was appropriately direct labor. If I had to guess, the cost driver still direct labor, which is inappropriate. Business has developed into a much more machine-oriented environment resulting in labor essentially being an indirect cost.

When an incorrect cost driver is assigned, a company cannot possibly have a good handle on their cost information. When you do not have a good handle on your costs, you have no way of being confident in the fact that you are covering all of your costs.

It is possible this business recognized their costing is poor. Yet, since cash is good the problem is ignored. Costs could be accurate and cash could be even better! In time, the business will be forced to address the situation and ultimately be amazed by how effective their system can be.

Categories: Cost Accounting