If you’re a business owner, it makes sense that you want to look for ways to increase your profit. Your business will not be successful and might even stagnate if you don’t find opportunities to improve your bottom line. That’s detrimental for a mission-driven business since it means you won’t be able to spread your mission and reach the people you want to serve.
But do you know the one number you need to know to make your business a success?
Focusing on your gross margin can tell you if your business is profitable and sustainable. But improving your gross margin can be tricky. It’ll need a lot of effort and work on your part.
So what exactly is gross margin, and why should you care?
What is Gross Margin?
Gross margin is the amount of money that your business has left after incurring the direct costs associated with producing the goods and services you provide. Such costs would include labour and materials. The higher the gross margin, the more revenue you have to cover other indirect costs and expenses — like taxes, interest on debt, and more — and generate profit.
How to Calculate Gross Margin
Your gross margin is your company’s revenue minus the cost of goods sold.
Sounds pretty simple, right?
In this equation, revenue is the total amount of money generated from sales for the period. Cost of goods sold refers to the direct costs associated with producing goods. Your costs of goods sold may include:
Products purchased for resale
Direct labour in production and selling goods
Equipment and utilities
Simply put, the cost of goods sold should include the cost of all the materials and labour that went into producing your company’s goods and services.
Calculating the gross margin is a two-step process.
First, you need to determine the gross profit. That is the revenue minus the cost of goods sold. You can find these numbers in the company’s financial statements. Once you find gross profit, you can calculate the gross margin, which is typically presented as a percentage. The formula for that would be:
(Revenue – Cost of Goods Sold) / Revenue
The figure can vary dramatically depending on the industry. For example, a company that sells electronic downloads through a website may have a high gross margin since it doesn’t have any physical goods that would incur additional expenses. On the other hand, physical products will surely cost more, which may result in a lower gross margin.
Wait… but what’s the difference between gross profit and gross margin?
The gross profit is a measure of absolute value. Meaning, it’s simply the difference between a company’s sales and its direct selling costs. Meanwhile, the gross margin is a ratio. Essentially, it’s a company’s gross profit expressed as a percentage of sales. It puts gross profit into context by taking your company’s sales volume into account.
Why is gross margin so important?
Gross margin is a good yardstick for measuring how effective your company is at converting the goods, materials, and direct labour into profit. By determining how much profit you gain through calculating the gross margin, it presents the following advantages:
It helps you determine how to improve. If you have a low gross profit, that would be an opportunity to change or improve your products or processes.
It provides a benchmark to compare with competitors. Depending on the increase or decrease of gross margin, you can figure out if your market is highly competitive or not.
It allows you to set competitive pricing. You can price competitively while still making sure that your products are still profitable.
Ideally, depending on your business, your gross margin should be above 30% which indicates profitability and sustainibility. But the definition of a “good” gross margin highly depends on your industry and whether you’re a startup or relatively new business.
Factors Affecting Gross Margin
Gross profit and margin are affected by different factors that must be closely monitored by your CFO or even yourself:
Materials price changes
Labour price changes
Inventory method changes
How can you improve your gross margin?
Gross margins are often determined by pricing strategies as well as understanding the cost of serving your customers or creating your products.
Here are other ways you can improve your gross margin:
Avoid markdowns by improving inventory visibility.
Streamline your operations and reduce operating costs.
Increase your average order value.
Implement better purchasing practices.
Increase your prices.
Be smart about discounting your products and services.
Identify and eliminate waste.
Focus on getting more sales from existing customers.
Determining your gross margin is an easy, reliable, and straightforward way to understand your business’ core elements. With this one number, you’ll learn how to keep your business profitable and sustainable in the long run. If you want to discover how to leverage and improve your gross margin, schedule a call with the Profit Reimagined team!