Gross margin

Gross margin

Gross margin is an important metric for investors, as it can give them insight into a company’s overall financial health. A company with a high gross margin is likely doing well and generating a lot of profit from its sales. On the other hand, a company with a low gross margin may struggle to generate profit and be in financial trouble. 

What is gross margin? 

Gross margin is the difference between a company’s revenue and the cost of its goods sold. It’s a key metric for evaluating a company’s financial health, indicating how much profit it can generate from its sales. 

A high gross margin indicates that a company efficiently turns sales into a profit. In contrast, a low gross margin means a company is struggling to profit from its sales. 

Understanding gross margin 

Understanding and keeping an eye on gross margins may also assist business owners in avoiding pricing issues, losing revenue on sales, and eventually, going out of business. Making sense of abnormalities in your income statements gets difficult if you don’t understand your gross margin. 

Many firms doing well sometimes fail because their costs are excessively high or their pricing is too low, making it impossible for them to make a profit. Establishing a common pricing strategy is alluring, especially when facing fierce competition. Still, it is rarely durable, and it can be challenging to raise rates later, even with a strong client base. You may prevent price errors before it’s too late by using gross margin estimates and other considerations as you develop your business. 

Another challenge for small business owners is cost control. Staff can easily neglect cost control processes, which can quickly reduce their profit margins. You have a problem, for instance, if more expensive materials have entered your production process. 

You can find these issues before it’s too late by being aware of your gross margin on each product throughout your business and responding to any deviations you see. 

Formvula of gross margin 

The formula for gross margin is: 

                            (Net sales – the cost of goods sold COGS) 

Gross margin = ———————————————————  x 100 

                                               net sales 

How to calculate gross margin? 

Calculating the gross margin is simple if you’ve been in the company long enough to have some experience with record keeping. However, for new businesses, the procedure is a little more difficult. 

Look at historical data for a business quarter or year, and determine your company’s total revenue for this period and the expenses of products sold to begin calculating the gross margin for an existing company (raw materials and labour). 

There are a different ways to calculate gross margin, but the most common is to take the company’s gross profit (revenue minus the cost of goods sold) and divide it by income. This will give you a percentage that you can use to compare different companies. 

(Revenue – Cost of Goods Sold) / Revenue = Gross Margin (%) 

If you’re calculating a startup’s gross margin and don’t have any revenue reports to use as a guide, you’ll need to study your prospective gross margins. Think about the following: 

What is the competitor doing? To determine where your gross margins should be, look up the averages for your industry or the gross margins of your rivals. Even though their financial information is private, their price and your knowledge of expenses can help you make an educated guess about your margins. 

Analyse your expenses and look at ways to reduce them over time. This should provide you with an early idea of your company’s profitability. Remember that gross margins shift over time when costs decrease, and efficiency is gained. 

Example of gross margin 

Let us look at the following example. A year or so has passed since Lexi’s small business began operating. Lexi wants to understand more clearly how costs impact her business’ bottom line. She then opens her accounting programme and begins to perform some calculations. 

She has made a total of US$500,000 from sales for the entire year. 

She has a US$435,000 cost of goods sold. The costs of producing the items she sold, including raw materials, labour, and production overhead, are included in the price of goods sold.  

She carried out the following computation to determine gross profit in dollars: 

US$500,000 – US$435,000 = US$65,000 

In other words, Lexi made a gross profit of US$65,000, and her gross margin was 13%. 

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