How to Avoid Margin Leakage

Profits are constantly under attack. Production costs inch upward. Shipping expenses rise. Competitors lower their prices. Inventory gets damaged. And customers always want more for less — more discounts, higher advertising allowances, better credit terms.

All those challenges squeeze profits. Sharp managers know that calculating profit is more than a matter of simply subtracting your costs from your selling price. There are lots of ways that profit margins can leak away throughout the entire sales and fulfillment cycle. The trick is to identify and seal those leaks while finding ways to serve customers better. Maintaining profit margins requires vigilance and hard work for all businesses, regardless of their size or how well established they are.

What Is Margin Leakage?

Margin leakage is the profit lost through erosion in a selling price (a form of revenue leakage) and by accretion in costs (margin compression). Both forces naturally occur in many businesses and may increase over time, so it’s important that business leaders continually review processes and policies with an intent in mind to maintain profitability.

Often, margin leakage can stem from trying to better serve a customer. Examples of well-intentioned revenue leakage occur when companies offer customers free shipping, quantity discounts or the right to return unused or unsold inventory. At other times, a company’s margins can be compressed by unintended operating issues, such as inventory damaged by careless handling or during shipping. Beyond that, company policies may leave gaps that allow margin points to be lost, such as by not requiring competitive bidding for supplies or through inconsistent expense analyses.

All these issues can cause operating margin to slip through a business’s fingers. You may start with a 30% profit margin, but the “pocket margin” — the profit in your pocket when all is said and done — may be much lower. Controlling margin leakage is key to increasing, or at least maintaining, profitability. What kind of magnitude is involved? According to some studies, a price reduction of a mere 1% would lead to an 11% dip in profit. So, guard pricing carefully to avoid revenue leakage that could have an outsize impact on the bottom line.

Key Takeaways

• Regular, consistent review of processes and policies can reduce margin leakage.
• Data is the key to understanding where profit margin is leaking away.
• Supply chain, overhead and sales processes are typical areas from which companies can recapture leaked margin.
• Actively managing prices, including disciplined use of discounts, is important to reduce revenue leakage.
• Automating your processes and establishing key performance indicators can help identify and minimize the impact of margin leakage.

Margin Leakage Explained

Margin leakage is the reduction in profit caused by price erosion, increased costs or a combination of both. Often, it stems from preventable inefficiencies in the business. There are many ways that margin can leak, but most of them can be fixed by identifying them, understanding how they happen and putting processes and procedures in place to minimize them. To accomplish this, businesses need high-quality data about their entire value chain, from marketing and sales — especially customer pricing, lead management and the sales process — to operations, such as manufacturing and procurement, and all the way through the entire supply chain to final delivery and payment. Doing all this with manual processes and data collection is time-consuming and error-prone and makes the points of margin leakage hard to find and fix. Automated systems, on the other hand, can provide necessary alerts and data in real time, improve information accuracy and impose important discipline on a business, all of which renders margin leakage easier to spot and mend.

Causes of Margin Leakage

Some margin leaks away due to inefficiencies in operations, like poor inventory management or uncontrolled selling expenses. Other leak points, like flawed pricing approaches or procurement processes, are more systemic — in other words, they emerge from an organization’s policies and systems. And still others can be blamed on unchecked inefficiencies, like overspending, over-ordering or over-hiring.

Inefficient Pricing Strategies

Setting prices correctly is as much a science as it is an art. It requires businesses to have enough good, clean data to understand all their product costs and to be aware of everywhere else their margin could potentially be spent. Scrutinizing such data, a business may discover that its pricing doesn’t cover all of its cost of goods sold (COGS), that it hasn’t segmented the market correctly or that it doesn’t fully understand the value that its product brings to customers. Beyond just the list price, it’s important to study the details of discounts, rebates, promotions and other conventions that reduce the actual net price coming in from customers. Many businesses still rely on outdated manual data collection for such analyses — if they do them at all — but automated data-gathering and -analysis usually leads to better, faster and more authoritative pricing decisions.

Inaccurate Cost Estimations

If you don’t understand all your costs, it’s far too easy to make bad estimates that turn into expensive mistakes. Like many business mistakes, this one usually comes from poor quality — or a total lack of — data and/or communication. Estimates that are too low for raw materials in manufacturing businesses, or for labor hours in both manufacturing and services businesses, will lead to margin compression. So will inaccurate estimates for outbound shipping costs, making it important to be as precise as possible when accounting for factors like volume and distance. Similarly, imprecise estimates for the true impact of returns, stockouts and overtime can obscure a business’s true costs.

Poor Inventory Management

Ineffective inventory management can cause both types of profit margin depression: revenue leakage and margin compression from added costs. For example, a business can leak revenue from a discounting strategy that’s a good idea when there’s plenty of product to move but might cause stockouts and customer make-goods (rainchecks) if inventory is tighter than expected. Similarly, consigned merchandise might be frozen with one customer even when another is ready to place a firm order, sparking a missed revenue opportunity. On the cost side, improper physical handling of inventory or careless packaging can increase costs due to high breakage/spoilage levels. And higher-than-needed inventory levels can cause margin erosion from increased storage, utilities, security and labor costs.

Overhead Costs and Expenses

Controlling overhead and riding herd on expenses are good business practices at any time, but they’re also a clear way to prevent margin from leaking away. Does the business need all the warehouse space it’s paying for? Are salespeople overspending on travel and entertainment? What recurring corporate office expenses haven’t been reexamined in the last few years? It’s easy to get into spending habits that start out as reasonable or one-time expenditures but grow and become entrenched over time.

Inadequate Supplier Management

Just as businesses need to manage customer and employee relationships, they need to monitor their suppliers, too. If suppliers’ prices are creeping up, that will appear on the books as increased raw material expense — and margin will leak away. Try to find ways to cut supplier expenses; maybe collaborate with suppliers on ways to use less-expensive materials or ask for a volume or prepayment discount, faster turnaround on orders or better shipping terms. In addition, to maintain leverage, keep suppliers competitive by rebidding contracts and spreading purchasing among several vendors. If necessary, look for new suppliers if existing ones won’t cooperate in helping drive profit to your bottom line.

Business Effects of Margin Leakage

Margin leakage can have a significant negative impact on any business, but it’s actually a symptom of something potentially worse: either a lack of management discipline or poor understanding of internal processes, both of which are often rooted in poor data. If you spot any of the following signs of margin leakage — especially if profit margins are lower than expected — your first step should be to gather the data for analysis that will help identify the underlying causes.

Reduced Profitability

If less money drops to the bottom line even when sales are steady or increasing, that’s a sure sign the business is leaking margin. Reduced profitability can be cured with granular attention to business details, so this is the time to review pricing strategies, operational efficiencies and cost management. Even if you don’t find a big problem, regaining small trickles can add up.

Increased Risk of Financial Losses

If profitability erodes far enough, the business may actually lose money. It’s possible to leak so much margin that the old wisecrack becomes true: The business is booming but it loses money on every sale.

Limited Growth Opportunities

Even if the business isn’t incurring losses, less profit means less money to invest in growth. That may hobble the business’s ability to take advantage of growth opportunities that it develops or discovers. This is a double whammy because the business misses out on two crucial opportunities: today’s profit and tomorrow’s growth.

Negative Impact on Brand Reputation

If a business leaks so much margin that its reduced profitability prompts cost-cutting measures, customers (and competitors) will notice. Lower-quality products or services, inconsistent pricing/heavy discounting or a falloff in customer service all can damage a brand’s reputation in the long run.

How to Avoid Margin Leakage

With all the risk that accompanies margin leakage, it’s vital to identify and plug the financial holes through which your margin is dripping. That can be difficult and time-consuming, because it requires a meticulous review of the business’s processes and procedures. The various ways to avoid margin leakage have common underpinnings: instituting better controls, vigilant monitoring and early identification of revenue and expense trends (good and bad). To be done well, all these steps require accurate data, clean bookkeeping and access to real-time information. The reward, though, is more profit and more opportunity.

Accurate Pricing and Cost Estimation

The first and most obvious place to look for margin leaks is in pricing formulas and the business’s approach to estimating its costs. The business may be undercharging relative to the market, the value that products or services are creating for customers, or customers’ ability/willingness to pay. Similarly, the business might be underestimating its true cost structure and, therefore, not building actual costs into product prices.

Use a Price Waterfall Framework

A price waterfall framework is a useful tool to help examine where revenue leakage might be happening by visually graphing deviations from a product’s list price to the “pocket” price the company receives. As its name implies, a price waterfall requires that you map out and track the flow of money. A simple waterfall model would take into account items that reduce net revenue, like cash discounts, marketing incentives or discounts, consignment, marketing allowances, free delivery and returns. It can also uncover increases in costs from consignment, inventory carrying and freight. A price waterfall can be an important reality check that helps you examine every place in the sales and fulfillment process where the business may inadvertently be giving away revenue or increasing costs. Once you understand the true pocket price, you can make adjustments. For instance, experiment with increasing volume discounts to see if that leads to greater sales.

Efficient Inventory Management

One hidden place where profits leak away in many organizations is inventory management. Does the business have too much product on hand, tying up cash and forcing it to discount prices to stay liquid? Is high inventory creating additional storage and handling costs? Conversely, is inventory so lean that you can’t take advantage of quantity discounts from suppliers and/or it leads to rush-shipping charges from suppliers when stockouts occur? Do you have excess breakage caused by careless warehouse handling or inferior packaging? Careful analysis of key inventory accounting metrics can help answer all these questions.

Tight Control of Overhead Costs and Expenses

A classic way to lose expected profit is by overspending on overhead expenses. Consistent and timely analysis of expenses can identify where spending is over budget or unexpected. Make the organization’s responsible managers accountable for overhead expenses by conducting periodic business review meetings with them. Create a culture where everyone is encouraged to think about efficiency and process improvement. Do you need all the office or warehouse space you’re leasing? Can you cut back on or get more out of travel and entertainment spending? Are some salespeople underperforming or not earning back their draw?

Adopt a Lead-to-Order Process

Consider formalizing sales processes under a lead-to-order (L2O) framework to better identify any leaks in the sales funnel. An automated L2O process starts with acquiring and qualifying leads. Then the lead moves through an opportunity management process where budget, timelines and product requirements are settled and a price is agreed upon. Once the customer confirms the order, the business generates an invoice and tracks both the delivery of products/services and invoice payment. The automation of a formal L2O process can save time and impose discipline on an ad hoc sales process. Using L2O provides information about how many leads close, and it can assist in identifying and closing revenue leakage at the earliest stages. Furthermore, L2O helps raise customer acquisition efficiency by increasing your understanding of why some leads didn’t buy and by assisting with customer retention. Strengthening retention boosts margin because it’s a lot less costly than finding new customers all the time. A well-controlled L2O process also hones revenue forecasting, which aids inventory purchasing and labor scheduling.

Effective Supplier Management

Is the business using the best possible suppliers? Are you sure? Are you getting their best price? Again: Are you sure? When did you last check? One way to improve profit margin is to pay less for what you sell. Establishing policies for periodic competitive bidding and quality-control checks can help ensure that costs are optimized and profits are not slipping through the cracks.

Ongoing Monitoring and Analysis of Margin Performance

Pricing and profit monitoring is not a one-time exercise; on the contrary, it requires constant attention. Automated processes can help. Automation imposes discipline on sales processes that might otherwise leak revenue margin. It discourages costly ad hoc deals and speeds time to closing deals. In addition, automated processes can provide fast feedback on the state of the business and how it got there in ways that manual processes simply can’t. Automated dashboards can provide business leaders with real-time key performance indicators (KPIs), issue alerts for potential profit-eroding problems and reveal trends that may require course corrections.

Use Price Optimization Tools

Consider using price optimization tools to ensure that you’re charging the highest unit price for maximizing revenue. Remember, pricing should not be static, because markets and customer needs aren’t static. Optimization software can keep track of customer segments and simulate how various customers might react to changes in price or value-added offers. Think of price optimization as akin to the way airlines price their tickets, with prices automatically rising and falling in alignment with demand patterns. It might not work for your business — or it might not work to the degree it works for airlines — but it may help the business achieve higher average unit prices for products or services.

Margin Leakage Examples

Margin leakage could be anywhere, eating into a business’s profits. Consider all the ways in which margin might leak in just this one hypothetical business scenario.

Commemorative Medallion Producers Inc. (CMP) sells custom-etched metal medallions to celebrate events or achievements of its corporate customers. CMP buys metal disks and decorative ribbons, silkscreens the disks to order, attaches the ribbons and sells the completed item in bulk for businesses to distribute to their employees. CMP’s gross profit margin is the sales price of the medallion minus the cost of the raw materials, the printing expense and labor for attaching the ribbons. Here are examples of the many places CMP might leak margin:

• Suppliers may not be offering the best possible price.
• Prices may be lower than necessary because CMP’s decision-makers are not paying close enough attention to the market, including what competitors are doing.
• The company could be tying up capital — and paying too much for warehouse space — by having excess raw material on hand.
• Customers could be demanding rush service and rush shipping and not paying enough to cover those costs.
• The company might be providing uncompensated value-added design services or undercharging for them.
• Salespeople could be offering unauthorized rebates or unwarranted volume discounts to save a sale and preserve their commissions.
• Invoices may go unpaid, increasing the company’s bad debt expense.

Reduce and Eliminate Margin Leakage With Manufacturing ERP From NetSuite

There are many ways profit can slip through a business’s hands, either from subpar revenue and sales processes or from operational inefficiencies. Manual processes contribute to all these problems. Hand-entry of information into spreadsheets takes time and effort, and even the best and most sophisticated spreadsheet models can’t always detect inaccurate input. Furthermore, manual tracking can’t always take special pricing or individual deals into account, which makes it difficult to enforce sales policies and pricing guidelines.

Whether to correct revenue leakage occurring somewhere along the many steps required to convert leads to sales or to prevent margin compression due to supply chain, operational or overhead inefficiencies, the best approaches to reverse the profit drain require accurate, up-to-date and accessible data. NetSuite for Manufacturing brings needed automation and visibility to business processes to help control margin leakage. The cloud-based, manufacturing-specific enterprise resource planning (ERP) system can automate pricing strategy and show you where you’re losing money, from dealing with suppliers to complex sales processes to invoicing and billing. NetSuite for Manufacturing offers the power and flexibility to support manufacturers’ processes and to adapt — and scale — as those processes change over time and as the business grows.

No business leader gets up in the morning and says, “I think I’ll let some profit slip through my fingers today.” But margin leakage is a constant, silent issue that prevents many businesses from becoming as profitable as they ought to be. Small leaks originating in various parts of the organization, from customer acquisition through sales, product fulfillment and delivery, can add up to significant profit loss. But the opposite is also true: Every step in a business’s processes is an opportunity to optimize profits. With greater visibility into each step, and by enhancing controls, close monitoring and analysis, margin leakage from pricing, sourcing and operational issues can be minimized or eliminated. Automated systems that allow managers to see where every dollar is going work better than manual systems, which allow for ad hoc arrangements that too often drain profit from the bottom line. Automated systems can help users analyze pricing, sales and collection issues, while enforcing operational processes and allowing flexibility, all of which leads to a healthier bottom line.

Margin Leakage FAQs

What is “margin” in accounting?

Margin takes several forms in accounting. Gross margin is the difference between a product’s selling price and the direct costs associated with making the product, otherwise known as cost of goods sold (COGS). Operating margin is more comprehensive and takes into account the operating costs of the business, including selling, general and administrative expenses, depreciation and overhead. Net margin is the complete profit or loss for a business, accounting for all revenue and all expenses, including interest, taxes and investment gains and losses. All these margins are expressed as a ratio or percentage of revenue.

What is price leakage?

Price leakage refers to deviations in a business’s list price compared to pocket price. Price leakage can occur, for example, from competitive pressure that results in excessive discounts or by the business giving away value-added services. Some price leakage can be OK, if it leads to a larger sale than might otherwise be made. But such deals require careful monitoring.

What is profit leakage?

Profit leakage is the erosion of margins caused by revenue leakage, margin compression (expense creep) or both.

What is margin pressure?

Margin pressure is any force — internal or external — that might lead to reduced profit margins. Margin pressure can come from a broad spectrum of factors, ranging from competitors lowering sales prices, increased costs from suppliers or any rise in operating costs, like excessive travel and entertainment by the sales team.

What role does technology play in addressing margin leakage?

The better a business’s data, the better its insights will be — and the better decisions its leaders will make. Technology, such as enterprise resource planning (ERP) systems, allows businesses to get global and detailed views of their processes and profitability that manual processes can’t provide. Technology enables business leaders to see where profit might be eroding at any stage of their processes, to set policies around those processes and to automate the enforcement of those policies. Technology, in short, can reduce or even prevent margin leakage that businesses might not even have known about when they were operating manually.