Knowing the gross margin ratio helps the small business owner to calculate sales revenue. Gross margin is a good tool to use in comparing a company's production efficiency over time. A decline in gross margin can imply that a company's product or service is becoming less competitive.
Gross margin is a vital part of the selling process. It’s the profit a company earns after deducting the costs to make and sell the product, or to provide a service. You can calculate sales revenue using the gross margin percentage.
What Is Gross Margin?
To get to gross margin, you must first calculate the gross profit. Gross profit equals revenue minus the cost of goods sold. This profit is also called sales profit and gross income. Once you know the total costs and the gross margin, you can then calculate the sales revenue you should earn.
Once you have the gross profit figure, you can calculate the gross profit margin which is expressed as a percentage of revenue and is used to compare a company’s production efficiency over time. Comparing only gross profits from year-to-year or quarter-to-quarter can be misleading because gross profits can rise while gross margins fall. You don’t want that for your company. Gross profit is expressed as a monetary value, while gross margin is a percentage.
The formula for gross margin is: Gross margin equals gross profit, divided by revenue and then divided by revenue. First, add up the cost of goods or services sold. (Do not include selling, administrative and other expenses; those are fixed costs.) Subtract the cost of goods sold from the revenue to get the gross profit, then divide the gross profit by the total revenue which gives you your gross profit margin or gross margin.
For example, if a company has sales of $1 million and the cost of goods sold totals $750,000, the gross margin sales revenue is $250,000. The gross margin percentage, or gross profit divided by total revenue, is 25 percent. So for every dollar spent, your company is earning an additional 25 cents.
Knowing the gross margin is useful to track trends, and investigate why a trend is occurring. A decline in the gross margin can imply a decline in the competitiveness of a company’s product or service. When considering gross margin, you should also consider your rate of inventory turnover.
Ways to Improve
You can improve your gross margin percentage in two ways. One is to buy inventory at a lower price. A substantial purchase discount, or a less-expensive supplier, will improve your gross margin percentage because the cost of the goods sold will be lower. The second is to mark up the goods or raise the price, but only do this with the competition in mind, because may lose customers.
Something to Remember
A low gross margin percentage doesn’t always mean your company is doing poorly. It’s better to compare gross margin percentages between companies in the same industry, rather than companies in different sectors. Gross profit margin is one of three ratios that measure your company’s profitability. The second is profit margin, which is how efficient a company’s management is. The third is net profit margin, or the company’s profitability after subtracting all expenses, right down to taxes and interest payments.