If you want to know or calculate the amount you are left after paying all the expenses, you can calculate Gross Margin.
Gross Margin is the amount of money your company or brand is left with after subtracting all direct costs of producing or purchasing goods or services you are selling.
Moreover, the higher the gross margin, the more money your company or brand is able to contribute to its direct costs and other expenses like interest.
This is why, gross margin is also referred to as contributing margin, a term that you use interchangeably.
You can express gross margin either in dollars or as a percentage of revenue.
While finance professionals use it as a measure of the operational performance of the company over time and to compare and rank groups depending on their performance.
Keep on reading.
Gross margin is a profitability metric that expresses the value in percentage.
It measures the portion of net sales revenue that your company will retain after accounting for the costs of goods you sell.
Moreover, gross profit is also known as profit margin as this measurement allows you to monitor profitability by comparing the revenue your company generates with ongoing production costs.
How can you Calculate Gross Margin? The gross margin formula is:
(net sales – the cost of goods sold) / net sales = gross margin
In this case, the costs of goods sold represent production costs.
This includes the costs of materials and labor.
While net sales represent foss sales minus any returns honored and discounts applied.
Both net sales and costs of goods sold can be found in the profit and loss statement of the company, It is also known as Income Statement.
An income statement is a financial statement that helps to calculate the new income of the company over a given reporting period.
Gross Profit vs Gross Margin
One of the important things to understand is that gross margin is different from gross profit.
Though you calculate both gross margin and gross profit for a particular period of time, you will represent gross profit as a total dollar figure and calculate it by using the formula:
net sales – the cost of goods sold = gross profit.
For instance, consider you want to calculate the gross margin and gross profit of a company that is selling Avenger-themed dishware.
This company is generating about $27,000 in revenue over the second quarter, with production costs totaling $10,000.
The gross profit of the company is $17,000 as $27,000(net sales) – $10,000 (the cost of goods sold) = $17,000 (gross profit).
However, in order to calculate gross margins, this company will then divide gross profit by net sales, arriving at a percentage of 63%.
Learn more about Return on Investments, ROI: Guide here.
Gross Margin vs. Markup
It is important to note that gross margin and markup are two different accounting term that uses the same inputs and analyzes the same transaction.
However, they tend to show different information.
Both gross margin and markup make use of revenue and costs as part of their calculation.
While the main difference between the two is that gross margin refers to sales minus the cost of goods sold and markup accounts for the cost of goods increasing in order to get to the final selling price.
Moreover, the right understanding of these two terms will help to make sure that the price setting is appropriate.
In case the price setting is too low or too high, it can result in lost sales or lost profits.
Over time, the price setting of the company can also have an effect on market share, as the price may fall far outside of the prices that competitors charge.
Net Margin vs. Gross Margin
Unfortunately, business expenses do not stop with the costs of goods your company or brand sells.
Gross margin isolates or only takes into account the profitability of the core offerings of your business.
However, it does not take into account or consider into account certain other factors.
These include administrative expenses and rents, non-operating expenses, or taxes.
Moreover, these figures instead tend to factor into the net profit margin.
You can calculate by subtracting the cost of additional business expenses from revenue before diving the remainder by net sales.
Net Profit Margin or Net Margin is expressed by the following 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 like you win a legal case or awarded damages, your net profit margin will likely be lower than the gross margin.
Furthermore, monitoring this metric alongside gross margins will help you isolate the percentage of revenue that your company will get to keep.
What does It Tell?
The gross margin or gross profit represents each dollar of the revenue your company retains after subtracting COGS, or costs of goods sold.
However, it is important to note that you can also refer to the gross margin as gross profit margin.
For instance, if a company has a quarterly gross profit of 35%, that means it retains about $0.35 from each dollar of revenue it is generating.
As you are already taking into account COGS, you can channel the remaining funds towards paying debts, general, and administrative expenses, interest fees, and dividend distributions to shareholders.
Companies use gross margin, gross profit, and gross profit margin to measure how their production costs refer to their revenues.
For instance, if the gross margin of a company is failing, it may strive to slash labor costs or source chapter suppliers of materials.
However, they may also decide to increase prices as a revenue-increasing measure.
You can use the gross profit to measure the company’s efficiency or to compare two companies with different market capitalizations.
However, if you find calculating gross margin to be difficult, you may find it easier to use some accounting software.
Advantages of Gross Margin
Monitoring gross margin is the key to improving the health of your business and increasing profitability.
As it is expressed as a percentage, the gross margin will not necessarily fluctuate as sales trends will go up and down in the same way as gross profit and net income will.
Instead, it is a pure expression of the potential profitability of your business model.
It helps to indicate whether or not you stand to make money at your current selling price.
Let’s discuss the advantages of gross margin in detail:
Helps to Inform Pricing
One advantage of calculating gross margin is that it can help you find whether you are pricing the company products or services appropriately or not.
Moreover, it can also help you respond to changes in the cost of materials which can affect your margin directly.
For instance, if you are working in the construction industry, you may experience fluctuations in the price of lumber and labor.
However, if the price of the material doubles and your selling price stays the same, the gross margin will decrease.
Consider another example:
You often change $480,000 to build a 1,800-square-foot while also knowing that your labor costs are a total of $180,000 and the cost of material will run you $130,000.
This will leaves you with a gross profits of $160,000 as $480,000 – ($180,000 + $130,000) = $160,000.
While your our gross margin (or gross profit / net sales) would be 33%, as $160,000 / $480,000 = .33.
Now let’s say that the labor cost in the third quarter increases by 1.3 and the cost of materials increases by 1.5
Your cost of goods sold will now be $234,000 (labor) + $195,000 (materials), or $429,000, your gross profit is $51,000, and your gross margin is 10.6%.
As you can see that there is a significant decrease in margins and it is a sign that your business needs either to find a way to reduce labor and material cost.
Or you need to increase the selling prices.
Provides Idea of the Porfatabilty of Business
As a measurement of the viability of the business model you are using, gross margins will give you a good idea of the profitability and the future profitability of your business.
For instance, let’s consider the above example of construction again.
While both gross margin and gross profit are flashing red warning signs, the gross margin particularly is helpful in assessing profitability.
This is because it accounts for fluctuations in sales volume.
Let’s say that this company is building 6 hours in Q3 and only one house in Q1, before the increase in the cost of goods sold.
In this case, the gross profit in Q3, i.e. $306,000 will exceed the gross profit in Q1, i.e. $160,000.
Therefore, monitoring only gross profit will lead this business owner to believe that the business is becoming more profitable over time.
However, when examining gross margin, it will show that there is a significant decrease in profitability that was disguised in gross profit reporting by an uptick in sales.
Indicates Growth Potential
All kinds of factors tend to affect the short-term profitability of your business.
Splurging on a top-of-the-line automated cow-milking machine may set your dairy farm back $20,000 in a single month.
And an atypically hot July may send ice cream sales soaring.
Neither of the above events,s however, is a good indicator of your growth potential.
In order to assess this, you will need a metric that will help measure how much money you will make on a sale.
Moreover, by telling you how profitable your business is before operating expenses are factored in, gross margin can help asses your growth potential.
A high gross margin will suggest that you can grow, while all you need to do is to increase profits is increase sales and minimize expenses.
However, if your gross margins are weak, going to increase profits by scaling your business will yield meager results.
Instead, you can increase profits and gross margin by raising your selling prices, lowering your production costs, or doing both.
Running a business, in some cases, be compared to building a place while flying it. Dealing with changing factors like material costs, staff turnover, and market-driven fluctuations in demand while also depending on the profitability of your business pay ent may feel like duct taping an engine in mid-air while also pulling up to avoid a mountain range.
However, you can think of your business as your flight plan and your accountant as a co-pilot. While you are putting out fires, metrics like gross margin can help make sure that you are on track to reach your goals, or let you know if you need to change the course to protect the bottom line.