Gross margin is net sales minus the cost of goods sold (COGS). Specifically, it's the amount of money a business keeps after earning the direct costs associated with producing the goods it sells and the services it provides. The higher the gross margin, the more capital a company retains, which then can be used to pay other costs, expansion projects, and satisfy debt obligations. The net sales figure is gross revenue, minus the returns, allowances, and discounts. When assessing the profitability of your small business, gross margin is one of the 3 main ratios to pay attention to, along with operating and net. If you do not pay close attention to these ratios, you will not completely understand how well your business is performing. This blog post from Union Commercial Capital breaks down what gross margin is and how it works.
What is Gross Margin?
Gross margin is your company's net sales minus your Cost of Goods Sold (COGS). In short, it's the retained revenue after incurring the total cost it takes to produce and sell your product or service. Your gross margin is what is left over to cover operating expenses within your business. Your gross margin will be a numerical value displayed on your business's income statement. It can also be displayed as a percentage of your sales. As you can imagine, a higher margin translates into more business revenue and more profit.
What is a Good Gross Margin?
What is a good gross profit margin ratio? A gross profit margin ratio of 50-70% would be considered healthy for many types of businesses, like restaurants, retailers, manufacturers, and other producers of goods. Measuring your gross margin will help you in budgeting and planning for your future growth. Having an up-to-date financial model can help with planning and understanding how forecasted margins may affect overall company growth and future revenue.
The gross margin varies by industry, however, service based industries tend to have higher gross margins as they don't have large amounts of COGS. In contrast, the gross margin for manufacturing companies will be lower as they have larger COGS. Having a high gross margin means you can grow your business more efficiently. A lower margin may mean you need to adjust to cost of your product or service.
Calculating Gross Margin
Let's explain how to calculate gross margin. It is simple to do so long as you have an up-to-date business income statement. To get started, choose the time-frame that you wish to evaluate, such as a month, quarter, or year. Then, look at the COGS for the same time-frame. Finally, you need to subtract your COGS from your total revenue, divide the number by your revenue, and multiply it by 100. Doing so will give you a gross margin percentage.
Formula:
Total Revenue – COGS ÷ Total Revenue x 100
As an example of how to calculate gross margin, consider a company that during the most recent quarter generated $150 million in sales and had direct selling costs of $100 million. The company's gross profit would equal $150 million minus $100 million, or $50 million, during this period. We can us the gross profit of $50 million to determine the company's gross margin. Simply divide the $50 million gross profit into the sales of $150 million and then multiply that amount by 100. The gross margin for this company is 33.3%.
Putting it to Use
Gross margin is a good yardstick for measuring how efficiently companies make money from products and services. It can therefore be used to more easily compare companies with different sales revenues. It can also highlight areas with opportunity for improvement; for example, if one product or service has higher gross profit margins than others, that could point to an opportunity to reduce COGS or shift the sales strategy for other product lines.
Next, your gross margin might also reveal that you are spending too much on the goods and products your business sells. When the costs of production, materials, shipping, and labor increase, your margin will decrease. So, be observant of your COGS and make the necessary changes, if needed.
How to Improve Your Gross Margin
How does a company improve gross margin? Traditionally, companies work to increase sales and lower production costs. However, retaining customers can improve gross margins in companies that rely on recurring revenue from subscription or service agreements. Here's how retaining customers can improve gross margins:
Improve ROI and cash flow
Spend less on customer acquisition costs
Increase sales
Also, gross margins can be used to create pricing strategies. Products are often priced based on the market standard. Companies within a given market accept "standard" margins rather than explore pricing options. Some business will decrease margins to increase gross sales in hopes of finding the perfect price point. Others will attempt to increase margins by setting higher prices and marketing value adds. Careful examination of gross margins can help create the ideal pricing strategy to guarantee higher profits and a healthy financial future.
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