If it feels like ages since you took Accounting 101, here's a detailed refresher on how understanding gross margins can help you make the right business decisions.
Ignore your financial statement, and you effectively ignore the health of your company. A good manager should be able to deftly use the gross margin to understand which areas of the company are performing well and which areas need improvement. But without a solid knowledge of all the factors that go into the simple calculation, the number itself can be useless.
Calculating a gross margin is fairly straightforward — it's gross profit divided by total revenue. Straightforward, right? This guide will explore what the number truly means for a business, and how it can be used to make the right decisions for your company.
Calculating Your Gross Margin: Why it's Simple but Significant
The gross profit margin is basically the amount you make per unit sold, says Akira Hirai, the founder and CEO of Cayenne Consulting, a Phoenix-based firm that helps entrepreneurs develop business plans and financial forecasts. For example, if you sell your product for $10 and it cost you $6 to make, you've made gross profit of $4. Therefore, your margin is 40 percent. It's important to keep in mind, too, that when referring to gross profit margin, you're only taking into account the variable costs and not the fixed costs.
The calculation really comes in handy when you're trying to determine your break-even point, or what you must charge in order to turn a profit. Hirai offers this example: "Suppose your fixed costs comes to $400,000 per year. If your gross margin is $40 per unit sold, then you need to sell 10,000 units before you break even. If you can find cheaper suppliers (or sell at a higher price) so that your gross margin increases to $50 per unit, then you only need to sell 8,000 units before you break even."
Another important use for gross margins is to benchmark your company against other companies in your industry, Hirai says. If your gross margins are higher than your competitors, it means you are either managing to sell at a higher price, or you have a better cost structure. He says: "On the flip side, if your gross margins are lower, you need to find opportunities for improvement."
Increasing profit should be the goal of any company. Profit is "the engine that pays for and runs your business," says Joe Knight, co-author of Financial Intelligence and owner of the Business Literacy Institute. "Every business wants to generate as much gross profit as possible, because its fuel that feeds and runs the operation."
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Calculating Your Gross Margin: Determining Company Efficiency
The calculation of gross profit is net sales - cost of goods sold, or COGS. So when thinking of gross margins, it is critical to look at the costs in order to understand company efficiency. "By understanding the components of COGS, and the industry average for the company, we can get an early indication of the efficiency and potential profitability of the business," says Pablo Bonjour, founder and CEO of SMG Business Plans, a company based in Katy, Texas, that offers entrepreneurs assistance in writing business plans.
In the case that the gross margin indicates to a manager that the company needs to be more efficient, costs should be the first element to be assessed in order to increase profit margins. "One hopes that the company has found a way to reduce their COGS, perhaps by buying in bulk, contracting with a supplier willing to make a deal, signing a long-term contract for a lower unit cost, etc.," Bonjour says. "If this is the case, we can say that the company has an opportunity to be a more efficient producer within its operating segment."
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Calculating Your Gross Margin: Finding the Industry Sweet Spot
Staying in tune with industry averages and trends is key. The same idea applies for the gross profit margin: Try to find the gross profit margins of competitors, and set goals from there. Private companies may be reluctant in releasing their cost figures, but their pricing is always available and can be used to give you an idea of where your gross margin should lie.
For example, digital goods can have very high gross margins, says Hirai. This is because "you aren't delivering anything physical to the customer," he says. "This includes downloadable books, music, and software."
Alternatively, companies selling high-priced goods in highly competitive markets like automobiles tend to have fairly low gross margins, Akira says. Selling in large volume in low margin industries is also fundamental to success.
For example, companies like Walmart and Target have margins that are well below 5 percent, says Knight. They make money by volume and they don't have a lot of risk.
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Calculating Your Gross Margin: When the Numbers Suddenly Change
The reporting of company costs can be a source of accounting fraud, so it is important to take note of any significant changes in the company's gross margins.
'If a company's gross margin is changing dramatically from quarter to quarter or year to year, a review of the footnotes and the accounting methods used for each component of COGS should be reviewed for the cause," Bonjour says. "An astute reviewer should be able to identify the cause. If there is no good explanation, fraud could be the culprit."
Clearly, any unanticipated change in the gross margin should be investigated, even if there's a completely logical reason. "There are many legitimate reasons why gross margins might change over time," notes Hirai. "Greater competition, changes in the regulatory environment, new suppliers, or volatility in commodity prices, to name a few. Be curious and vigilant, and seek to understand why your firm performs the way it does."
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Calculating Your Gross Margin: Improving the Profit Margins
The crucial reason to use the gross profit margin is that it tells you how much money your company is generating from your product or your service that you can use to pay for your operation. You'll always want to be increasing your gross profit margins, which can be accomplished in one of two ways: increase profit or decrease costs.
"You can improve net revenues in several ways - by increasing your pricing, reducing discounts offered by your sales team, or reducing returns and bad debts," says Hirai. "And you can improve the cost of sales by sourcing cheaper suppliers (perhaps by ordering in larger quantities) or improving production efficiency. Some companies improve gross margins by shrinking the product size without reducing the price."
While it's always good to achieve a higher gross profit margin for your company, the gross margin is only one measurement among many that indicates the overall financial health of the firm. "True success comes when many things are all working at the same time," Akira says. Happy customers, happy employees, good growth rate, good liquidity ratios, good debt ratios, good operating expense levels, and much more. Gross margin is just one tool in your financial management toolbox."
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