March 21, 2022

Past Gross Margins Predict Future Gross Margins

Here's an issue I recently analyzed ... let's say an item costs $50 and the cost of goods sold are $30, netting the brand a $20 gross margin on the item.

Second issue ... the item costs $50 and the cost of goods sold are $30, but the brand sells the item for $40, leaving only $10 gross margin on the item.

Why do we care about the two issues above?

Well, past gross margins predict future gross margins. In other words, I created a regression equation for a brand where I had two independent variables (gross margin dollars, cost of goods dollars) and one dependent variable (future gross margin dollars). Here's what the equation said:

  • Future Gross Margin Dollars = $12 + $0.55*(Past Gross Margin Dollars) + $0.06*(Past Cost of Goods Sold Dollars).
Ok, that's a lot of geeky stuff there.

Now let's see how the equations forecast future behavior.

In the first "issue", here's how the equation plays out:
  • $12 + $0.55*($20) + $0.06*($30) = $24.80.
In the second "issue" where discounting was present, here's how the equation play out:
  • $12 + $0.55*($10) + $0.06*($30) = $19.30.
Do you understand what just happened there?

The model suggested that if a client discounted to a customer, the customer would generate $5.50 fewer gross margin dollars (and consequently, less profit as well) in the next year.

Of course, this should raise all sorts of questions ... cause and effect questions. Y'all will debate these for a long time, many will argue on the basis of an opinion.

Regardless of the questions, the equation suggests that past gross margin dollars predict future gross margin dollars. Do things to erode profit today, and you have less profit tomorrow.

Think about this topic, ok?

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