Expansion Without Gross Margin Is Committing Suicide
Gross margin is a company’s total sales revenue minus its cost of goods sold (COGS), divided by total sales revenue, expressed as a percentage. … The higher the percentage, the more the company retains on each dollar of sales, to service its other costs and debt obligations.
Gross profit margin is the percentage of your company’s revenue that converts to gross profit. It is a key measure of profitability for a business. … Therefore, declines in margin generally occur because of shrinking revenue relative to sales volume or higher COGS. Gross margin is a company’s total sales revenue minus its cost of goods sold(COGS), divided by total sales revenue, expressed as a percentage.
The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services it sells.
The higher the percentage, the more the company retains on each dollar of sales, to service its other costs and debt obligations.
Taking production costs into account is important when measuring business success.
A company’s margins are a measurement of how effectively the company turns its revenue into profit. Gross margin reflects how much of its sales a company hangs on to after paying the up-front costs of producing the goods or services it sells.
It’s calculated by dividing gross profit divided by total revenue and expressed as a percentage. The less a company spends toward its cost of goods sold, the smaller the difference between gross profit and total revenue, and the greater the gross margin.
Understanding gross margin
The math behind calculating gross margin is easy, but understanding the concepts that produce those numbers takes a bit more work. In particular, the cost of goods sold can be a tricky term to understand.
Essentially, the cost of goods sold includes only those expenses that relate directly to production. For goods, spending on the raw materials that are necessary to make the final product is included in the figure. Labor costs for work that is directly related to the production process also find their way into the overall cost of goods sold. Related: 20 Green Business Ideas for Eco-Minded Entrepreneurs
Many other expenses aren’t included in the cost of goods sold and enter the efficiency equation at a later stage. For instance, marketing and advertising expenses are instrumental in getting customers to buy products, but they aren’t considered direct production costs. Such costs typically show up as operating expenses that leave gross profit unchanged but reduce operating profit.
The value of gross margin
The higher the gross margin, the more efficient a company is at producing goods and services. However, there are limitations to how much you can use gross margin for comparison purposes. Within a given company, seeing how gross margin changes over time can provide useful insight into internal improvements in productivity.
Between companies in a given industry, comparing gross margin can give hints as to whether one production method leads to superior results over another. Related:Entrepreneurs: born that way or raised?
Across different sectors, however, gross margins typically reflect the inherent differences in production processes, rather than any company-specific deficiency. For example, the aircraft production industry has consistently had low gross margins, with percentages in the teens throughout the past decade.
The expensive materials and skilled labor required to build airplanes are to blame for the low gross margin figures. By contrast, companies in the pharmaceutical and biotech arenas that already have established products tend to have high gross margins, because research and development costs are treated as operating expenses, while the costs of direct production are extremely low once treatment has gained approval. Related: 10 Great business ideas for 2019
In general, high gross margins indicate a strong company. This metric is just one piece of the puzzle when you’re evaluating a company, but gross margin’s focus on how efficiently a company produces goods and services is essential to understanding its overall financial health.
Calculations
There is no average gross profit margin for small retail business since every retail business is unique. To show the range of gross profit margins, consider that a retail grocery store operates with a gross profit margin of around 25 percent, while a small jewelry store can operate at a gross profit margin level of around 50 percent.
To calculate the gross profit margin for a small retail business, add a percentage of markup to the wholesale cost of an item or service. This provides a selling price. The difference between the selling price and the wholesale cost provides the gross margin price.
To determine the gross margin percentage, simply divide the gross margin price by the selling price. For example, if a ceiling fan has a wholesale cost of $55 and a markup of 40 percent, the selling price of the ceiling fan is $77. This gives a gross margin price of $22. When dividing the gross margin price by the selling price, the gross margin is about 29 percent. Calculated as gross profit divided by total sales.
This number represents the percentage of revenues that a company retains after paying for the basic costs of production (raw materials, employee salaries, and equipment).Related:Unique Business Ideas to Inspire You in 2020
The Gross Margin also demonstrates the percentage of revenues that are left available to be spent on other costs such as marketing, administration, and research and development. Therefore the higher the Gross Margin, the more a company has to spend on other activities to expand the business.
Parameters
Although there is no average gross profit margin for a small retail business, many small businesses operate within the parameters of having between a gross profit margin of 25 percent and 35 percent. It is important to remember that when operating expenses rise, it becomes necessary to increase the gross profit margin.
Failing to do so puts a business at a loss. In 2005, for example, independent booksellers had gross profit margins of slightly over 41 percent, yet had operating expenses of slightly over 42 percent, thereby causing many booksellers to operate at a loss.
Net Profit
When factoring in the gross profit margin, businesses always keep in mind the net profit margin. After all, the net profit margin is where profit for business comes in, as well as money for future investments.
If a business tries to get too high a gross profit margin, however, the pricing of an item or service might become too high, leading to a reduction in sales.
On the other hand, trying for too low a gross profit margin might lead to a reduction in net profits, leading to less money for business investments, as can be seen with the small independent booksellers who were operating at a loss.
Increasing Profit
To raise the net profit margin without making pricing too high in the gross profit margin, a business needs to reduce costs, either by reducing the price of goods or by reducing the cost of labor.
This means that it costs less to produce or purchase an item, but by keeping the price constant despite the lower cost, the overall gross profit margin increases. Gross profit margins need to stay steady, and if they wind up dropping, adjustments must be made to keep the business profitable.
Small retail businesses sometimes operate at a disadvantage, since they cannot reduce the cost of goods or services the same way a large corporation can.
For example, someone operating a small retail clothing store usually cannot get a clothing wholesaler to offer the same pricing the store offers a large department store since the department store chain buys in bulk quantities. This means small retail businesses need to exercise vigilance over costs at all times, to ensure they do not operate at a loss.
Impediment to Growth
Lower gross margin results in less money being available to cover the operating costs of the business, including marketing expenses and administrative salaries.
Not being able to spend as much on marketing as competitors do will, over time, result in the company growing more slowly. In addition, there may not be enough cash to invest in projects that will upgrade the company’s long-range efficiency, such as information technology.
The company may not be able to pursue opportunities such as acquiring a competitor or expanding the geographic scope of its business. The company may not be able to hire sufficient staff to run the operations efficiently or attract the best talent.
Difference Between Gross Margin and Net Margin
While gross margin only looks at the relationship between revenue and COGS, the net profit margin takes all of a business’s expenses into account.
When calculating net profit margins, businesses subtract their COGS as well as ancillary expenses, such as product distribution, wages for sales reps, miscellaneous operating expenses, and tax.
Gross margin, also called gross profit margin, helps a company assess the profitability of its manufacturing activities, while net profit margin helps the company assess its overall profitability.
Different Types of Revenue
Revenue, for most companies, is pretty much the same thing as sales. However, an important difference between the two is that revenue is the more comprehensive term. It includes sales but also includes any other income, such as that from interest, rental properties, royalties or, in fact, almost anything else that produces non-sales income.
This distinction is one of the reasons that the gross profit margin calculation is a good approximate gauge of company health, but cannot be entirely accurate in certain cases. When calculating a gross margin ratio and analyzing the result, it’s important to know if you’re using total sales or total revenue.
If, for instance, a pharmaceutical company has licensed a drug to another company, in the first year of the drug’s release it may receive very large royalty payments. This non-sales revenue is a big change from other years, and so distorts the expectable revenue in future years.
What Is the Cost of Goods Sold?
Cost of goods sold (COGS) refers to a company’s variable costs only. This explains why the gross margin calculation, although useful, doesn’t tell you all you need to know to determine how well a company is doing.