Gross Margin Explained
Gross margin expresses in percentage terms how profitable your products and services are. It’s a way of determining and showing how much money you have left over after accounting for the cost of producing and selling your product
To demonstrate how this works, imagine that you are manufacturing and selling t-shirts. Your cost of goods sold will include the cost of sewing materials, fabric and the labour costs associated with producing the t-shirt
The cost of goods sold does not include other operating expenses such as rates, insurance, taxes, accounting costs and other professional services.
Applying the Gross Margin Formula
The gross margin formula is a simple equation which is Gross Margin = Revenue less the costs of goods sold divided by revenue.
To demonstrate how this works let’s extract the relevant information from this sample revenue statement to determine gross margin.
Interest Income $212
Cost of Sales $30000
Cost of Goods Sold $30000
GROSS PROFIT $60000
If we extract revenue and cost of goods sold from the statement and apply the formula we get the following
Revenue $90000 less Cost of Goods Sold $30000 = $60000
60000 divided by Revenue 90000 = .66
The Gross Margin therefore is .66 or 66%
This percentage tells us that for every dollar made in sales the business is making 66% profit.
It is in the healthy situation of selling its products for more than they cost.
The Difference Between Gross Profit and Gross Margin
While gross margin and gross profit are essentially looking at the same key elements of the business, there are several differences between them.
Gross profit expresses in dollar terms how much profit is being made in relation to the cost of goods sold while gross margin expresses this margin as a percentage.
The formula for gross profit is simply revenue less cost of goods sold equals gross profit
Why Is Gross Margin Important?
Gross margin is a great way to determine how efficient your production process is . A good gross margin shows that you can produce your product profitably
Finding ways to improve your gross margin will improve your overall profitability.
As the formula indicates, gross margin can be improved in one of two ways either by raising revenue through price increases or lowering the cost of goods sold
Choosing to raise prices presents problems particularly with your customer base who may decide to choose an alternative product. Therefore before raising prices it’s a good idea to research the marketplace In terms of competitors pricing and product quality. When you raise the price you have to be sure that your product will remain competitive on these terms
Lowering the cost of goods sold can be done by negotiating or sourcing lower prices for the materials used to manufacture the product. There may be bulk buying options to take advantage of or potential savings to be made when your suppliers are looking to clear stock.
From the point of view of keeping your customers happy, lowering the cost of goods sold is always a better option then raising prices.
Of course gross margin is just one component of your financial statements and potential investors buyers and other interested parties will want to examine such items as expenses, net profit and other metrics to gain an overall understanding of the financial health of your business.