Why your gross margin is tanking? How to analyze profitability

🛠 THE CFO EFFECT PLAYBOOK (Part II)

Step 1: Always start by clarifying the ask

The number one reason finance pros fail this question is they don’t ask questions.

And the first interrogation that should come to mind when you have any challenge is: what’s your definition of gross margin?

While most people think it’s pretty straightforward, I’ve seen different companies with different definitions.

For the purpose of this exercise, gross margin is the gross profit divided by revenue.

But don’t stop here. The next question you would ask would be what’s the definition of gross profit?

Gross profit is the difference between the revenue and the cost of goods sold (also known as COGS).

Most people would stop here, but finance is about asking questions; a lot of them.

How would you define COGS?

I’d say it depends.

Usually, your industry determines your COGS.

Technically, COGS should include anything that comes into the composition of what you sell.

For the purpose of this exercise, we will look at a distribution company.

They import products from Asia and sell them in the US, Canada, and Europe.

The COGS include the cost of products, freight, tariffs, and customs brokerage fees.

If we were to look at a production company, it would be different.

Production companies would have raw materials, labour costs, transportation costs…etc.

As mentioned earlier, it really depends on what goes into making your products or services.

Step 2: Apply this structured framework

My framework is pretty simple.

It’s based on the fact that the best way to eat an elephant is one step at a time.

That’s why the first thing I do when someone asks me a question is dissect it to its components.

By doing so for this question you put your focus on the two things that could affect your gross margin: Revenue and COGS.

Then, you do the same thing with these two items.

Revenue is volume multiplied by pricing minus any return/refund (to get net revenue).

And COGS is also volume multiplied by pricing multiplied plus freight cost per unit…etc.

We mentioned earlier that we import from Asia, and the question that comes to mind is what currency do you use to pay for those imports?

Let’s say it’s USD.

Step 3: Analyze using clear strategic drivers

The question asked to explain the gross margin decrease which suggests two things: 1) analyse performance vs a previous period, and 2) analyze a ratio not an absolute number.

Since we’re analyzing a ratio, volume is not an important factor.

Therefore, we can ignore volume for now.

Because we asked the right questions earlier on in the process, here are the factors that could affect your gross margin:

1. Price

Your GM is a direct function of the price.

By price I mean the price of your product, and also the price you pay your supplier for those products.

If you decrease your selling price but your suppliers keep the same price or worse increase their price, your margins are going to suffer.

Pricing is a full topic in itself.

Pricing does not only affect your margins. It affects your sales, your branding, your positioning…etc.

That’s why it’s a topic that should be discussed with multiple stakeholders, with a final input from finance.  

2.  Foreign Exchange

Because the company buys in USD and sells in multiple currencies this could affect the margins.

Let’s say that the USD has increased drastically against the CAD and the company has fixed prices in Canada regardless of the FX.

Any increase in percentage of sales in Canada will have a negative impact on the margins.

The opposite is true, any decrease in percentage sales in Canada will have a positive impact on the margins.

If the USD decreases, then the situation will be the reverse.

3.  Discounts and promotions

Volume discounts, promotions and liquidations, will affect your margins negatively.

The question to ask is what’s the purpose of the promotion?

Are we trying to save the bottom line from inventory write-downs or write-offs?

Are we trying to reduce other expenses such as warehousing expenses or shipping expenses by benefiting from an economy of scale or a lower inventory?

Are we trying to reduce payment terms to have access to cash faster?  

4. Channel mix

Not all channels are created equal.

Direct to consumer has usually higher margins than selling to retailers or selling through marketplaces.

To analyze the situation, you need to review the profitability by channel and analyze the new vs old channel mix (in terms of percentage).

5. Product mix

A bit similar to the channel mix, not all products have the same margins.

Analyze your profit margin by product and compare the product mix for the two periods to understand which product is dragging down your profitability.

6. Returns/Refunds and warranty claims

When customers are not satisfied, they will ask for a refund or they will return the goods.

This will decrease the revenue but won’t affect the COGS, leading to a decrease in the GM.

Product quality cannot only increase the return rate but could also affect warranty claims leading to a lower net revenue and margins.

7. Landed costs

Landed costs will group tariffs, freight costs, demurrage, customs brokerage and anything linked to importing products into your market.

This item is pretty straightforward.

Any increase in landed cost that is not passed on to your customers through price increase will have a negative impact on your margins.  

8.  Inventory write down/write off

Most people won’t think about this one, but any slow-moving inventory could be either written-down or written-off.

When that’s the case, it will negatively affect your gross margin.

Step 4: The two analysis you MUST master

1. Horizontal Analysis (aka Trend Analysis)
   Ask: How are key metrics evolving over time?

   • Is revenue up or down?

   • Is gross margin shrinking or growing?

   • Are COGS creeping up quarter over quarter?

2. Vertical Analysis (aka Structural Analysis)
   Ask: What makes up each line item and how does it relate to the whole?

   • What % of revenue is eaten up by each cost driver?

   • Are shipping or material costs outpacing volume?

   • Is your gross margin % aligned with benchmarks?

These aren’t competing frameworks. They’re complementary.

Use horizontal to spot trends.

Use vertical to dissect why.

Let’s say your gross margin dipped from 58% to 52% over the last two quarters.

Here’s how you break it down:

• Horizontal Analysis flags the drop and shows you the trend.

• Vertical Analysis reveals the cause:

  • Did product mix shift toward lower-margin SKUs?

  • Did freight costs spike due to supply chain issues?

  • Did discounts increase due to market pressure?

This layered view gives you insight. And insight gives you leverage.

The Bottom Line (Your Strategic Action Checklist):

• Clarify First: Always start by defining key terms explicitly.

• Simplify the Problem: Break down complex financial questions into clear, manageable components.

• Identify Key Drivers: Quickly pinpoint your key strategic levers.

• Link Insights to Strategic Actions: Translate each finding into clear, actionable recommendations aligned with overall business strategy.

Next Week’s Episode:

🔜 Profitability and Variance Analysis: How to Explain the “Why” Behind Performance

Great finance leaders reveal the story behind performance.

Variance analysis isn’t about spotting differences; it’s about understanding why they happened and clearly communicating actionable insights.

Next Sunday, I'll give you a practical roadmap to master profitability and variance analysis, including:

✅ How to use horizontal and vertical analysis to quickly diagnose your financial statements
✅ How to explain year-over-year variances and turn them into strategic insights
✅ How to effectively communicate budget vs. actuals variances to drive immediate action
✅ Real-world case study: How top players uncover hidden opportunities
✅ How EBITDA margin analysis can pinpoint your true profitability drivers

Because when finance clearly explains the “why,” executives confidently know what to do next.

Ready to elevate your analytical storytelling and transform financial insights into strategic action? Don’t miss this episode.

Talk soon,