November 20, 2012

Gross Margin and Repurchase Rates

We seldom talk about Gross Margin.

We should talk about Gross Margin.

Gross Margin is what is left after subtracting the cost of goods sold.  If you sell an A/V Receiver for $300 and it cost you $240 to purchase the item from a vendor, then you earned $60 Gross Margin (60/300 = 20% Gross Margin).

Conversely, if you create your own products, you have an opportunity to earn more Gross Margin dollars.  Companies that create their own products frequently enjoy high Gross Margin rates.  For instance, if you sell a handbag for $300, you might earn $180 in Gross Margin after subtracting the cost of creating the item.

To achieve the same amount of Gross Margin dollars, the first company has to sell three A/V Receivers ($60 * 3 = $180).  The first company has to sell one handbag ($180 * 1 = $180).

Needless to say, the second company has an advantage.

If you have a low Gross Margin, you can generate a lot of profit via a high annual repurchase rate.  If 70% of last year's customers purchase again, you obtain downstream Gross Margin dollars that compensate for marketing expenses.

If you have a high Gross Margin, you can generate more profit via infrequent buyers.  Catalog brands have been around forever, managing 60% Gross Margins with 40% Annual Repurchase Rates.

If you have a low Gross Margin and a low Annual Repurchase Rate, you must achieve, as the online pundits like to say, "scale".  In other words, you need a highly viral product that causes numerous customers to purchase.

Now think about the Kindle.  Amazon states that they make no profit on the sale of a Kindle, zero Gross Margin dollars.  Amazon, however, has a high Annual Repurchase Rate (i.e. you're going to have to buy books to use your Kindle), and Amazon has "scale".  This causes the numbers to work out, over time.

Notice that all of the excitement starts with merchandise ... opposite of where most discussions start these days (social, mobile, omnichannel).  

Merchandise and Gross Margin, however, dictate everything that follows.

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