If you’ve watched the Winter Olympics, you know that figure skating scoring is complex. If a skater wants to know why they aren’t ending on the podium, their total score alone can’t answer the question. Instead, they must look at a percentage that measures how close their score is to the total points available. If the percentage is low, they need to focus not on adding more difficult moves, but on improving their execution. If the percentage is high, then their routine wasn’t difficult enough to accrue a high point total.
Just as they do for figure skaters, percentages can provide business owners with critical performance insights. And, as is the case for our theoretical skater, business owners can use percentage metrics to isolate problems and identify solutions.
In business accounting, one key metric expressed as a percentage is gross margin, which measures your potential to turn a profit under current pricing conditions by showing you what percentage of revenue is consumed by cost of goods sold and what percentage is left over to fund your business operations and accrue as profit. If your business isn’t generating the desired profit, evaluating gross margin can help you identify the source of the issue and implement a fix.
What is gross margin?
Gross margin is a profitability metric, expressed as a percentage, that measures the portion of net sales revenue that your company retains after accounting for the cost of goods sold. Also known as gross profit margin, this measurement allows you to monitor profitability by comparing revenue generated with ongoing production costs.
How do you calculate gross margin?
The gross margin formula is expressed as:
(net sales - cost of goods sold) / net sales = gross margin
In this case, cost of goods sold represents production costs (including the costs of materials and labor) and net sales represents gross sales minus any returns honored and discounts applied. Both net sales and cost of goods sold can be found on a company’s profit and loss statement (or income statement), a financial statement that calculates a company’s net income over a given reporting period.
Gross margin is different from gross profit, although both gross margin and gross profit are calculated over a particular period of time and are based on net sales and production costs. Unlike gross margin, gross profit is represented as a total dollar figure and is calculated using the formula net sales - cost of goods sold = gross profit.
For an example of how to calculate gross margin and gross profit, let’s say that a company selling Star Trek: The Next Generation–themed dishware generates $27,000 in revenue over the second quarter, with production costs totaling $10,000. This company’s gross profit is $17,000, because $27,000 (net sales) - $10,000 (cost of goods sold) = $17,000 (gross profit).
To calculate gross margins, this company would then divide gross profit by net sales, arriving at a percentage figure—in this case, 63%.
Gross margin vs. net margin
Unfortunately, business expenses don’t stop with the cost of goods sold. Gross margin isolates the profitability of a business’s core offerings, but it doesn’t take into account operating expenses (such as administrative expenses and rents), non-operating expenses, or taxes. These figures instead factor into net profit margin, which is calculated by subtracting the cost of additional business expenses from revenue before dividing the remainder by net sales.
Net profit margin (or net margin) is expressed by the formula:
(net sales - cost of goods sold - operating expenses - tax liability) / net sales = net margin
Unless your business experiences a significant influx of non-operating revenue (say, you win a legal case and are awarded damages), your net profit margin will likely be lower than your gross margin. Monitoring this metric alongside gross margin helps you isolate the percentage of revenue that your company gets to keep.
Advantages of gross margin
Monitoring gross margin is key to improving the health of your business and increasing profitability. Because it is expressed as a percentage, your gross margin won’t necessarily fluctuate as sales trend up or down in the same way that your gross profit and net income will. Instead, it is a pure expression of the potential profitability of your business model, indicating whether or not you stand to make money at your current selling price.
Gross margin can be used to inform pricing
One advantage of calculating gross margin is that it can help you determine whether or not you are pricing your company’s products or services appropriately. It can also help you respond to changes in the cost of materials, which affect your margin directly.
If, for example, you work in the construction industry, you may experience fluctuations in the price of lumber and labor. If the price of materials doubles and your selling price stays the same, your gross margin will decrease.
For example, let’s say that you typically charge $480,00 to build an 1,800-square-foot house, knowing that your labor costs will total around $180,000 and the cost of materials will run you $130,000. This would leave you with a gross profit of $160,00, because $480,000 - ($180,000 + $130,000) = $160,000. Your gross margin (or gross profit / net sales) would be 33%, as $160,000 / $480,000 = .33.
Now let's say that your labor costs in the third quarter increase by 1.3 and the cost of materials increases by 1.5. Your cost of goods sold is now $234,000 (labor) + $195,000 (materials), or $429,000, your gross profit is $51,000, and your gross margin is 10.6%. This is a significant decrease in margins, and it’s a sign that your business needs to either find a way to reduce labor and material costs or increase its selling prices.
Provides a good idea of a business’s profitability
As a measurement of the viability of your business model, gross margin gives you a good idea of the profitability (and future profitability) of your business.
For example, let’s return to the construction company discussed in the example above. While both gross margin and gross profit are flashing red warning signs in this example, gross margin is particularly helpful in assessing profitability because it accounts for fluctuations in sales volume. Let’s say that this company built six houses in Q3 and only one house in Q1 (before the increase in cost of goods sold). In this case, their gross profit in Q3 ($306,000) would exceed their gross profit in Q1 ($160,000).
Monitoring gross profit only would lead this business owner to believe that their business was becoming more profitable over time. Examining gross margin, however, reveals a significant decrease in profitability that was disguised in gross profit reporting by an uptick in sales.
Indicates growth potential
All kinds of factors can affect your business’s short-term profitability. Splurging on a top-of-the-line automated cow-milking machine might set your dairy farm back $20,000 in a single month, and an atypically hot July might send your ice cream sales soaring.
Neither of these events, however, is a particularly good indicator of your growth potential. To assess this, you need a metric that measures how much money you make on a sale.
By telling you how profitable your business is before operating expenses are factored in, gross margin can help you assess your growth potential. A high gross margin suggests that you are positioned for growth: all you need to do to increase profits is increase sales and minimize expenses. If, however, your gross margins are weak, attempting to increase profits by scaling your business will yield meager results. Instead, you can increase profits (and gross margins) by raising your selling prices, lowering your production costs, or both.
Final thoughts
Running a business is sometimes compared to building a plane while flying it, and for good reason. Dealing with changing material costs, staff turnover, and market-driven fluctuations in demand (all while depending on your business’s profitability to pay your rent) can feel a bit like duct-taping an engine in mid-air while simultaneously pulling up to avoid a mountain range.
Think of business accounting as your flight plan, and your accountant, if you have one, as your co-pilot. While you’re putting out fires, metrics like gross margin can assure you that you are on track to reach your goals—or let you know if you need to change course to protect the bottom line.
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