Gross margin, also referred to as gross profit margin, is a metric used in financial reporting to help companies gauge the overall financial health of their organization. The most common use of gross margin reporting is to assess an organization's additional expenses and savings potential.
Gross margin is determined by subtracting total revenue from operating expenses, or cost of goods sold, and dividing this result by total revenue. Particularly efficient companies that spend less on creating their goods will have higher profit margins. Conversely, companies that spend at or near the amount for which they sell their product to produce their product will have slim profit margins and less money to reinvest in their company.
Gross margin provides managers excellent illumination into the direct impact of company expenditures on their bottom line. When utilized to gauge a range of products in a company's manufacturing or production portfolio, gross margin can indicate which products are more profitable than others. Analysis of costs and production expenses can allow companies to target production saving initiatives such as alternative means of sourcing, manufacturing and assembly.
Gross margin reporting can save companies money by spurring them to shrink production overhead. Similarly, gross margin reporting can be utilized to target competition, particularly when margins are large. A company's ability to shrink the cost of its product on the consumer market can lead to increased sales, which by increasing total revenue can also positively impact gross profit margins. Companies that can produce their goods for less and sell more of them to target markets at a lower price have a distinctive advantage over their competitors.
Gross margin's major drawback is that it is simply an estimate. More dynamic metrics are needed to gauge more precise analysis regarding a company's overall profitability. While gross margin is inclusive of total production cost, it is not inclusive of other production-related expenses including packaging, shipping costs or shipping insurance, all costs which company management must consider when gauging their overall profitability.
