As a business owner or manager, you calculate a variety of figures to determine the health and longevity of your business. One of these figures is gross margin, which is an important factor for you when assessing your business risk and profitability … or when you are setting prices for your goods or services.
How is gross margin reported?
Gross margin is typically reported on the income statement, also known as the profit and loss statement for small business. You or your accountant calculates gross margin by taking total revenue and deducting the cost of goods sold or the costs directly associated with selling products.
The cost of goods sold. According to the IRS, the cost of goods sold (COGS) includes inventory, materials, the cost of labor, and any other distribution costs. Any sales returns or discounts are also deducted from sales to calculate gross margin.
Dollar figure and/or percentage. Gross margin indicates the amount of sales revenue a business retains after incurring the direct costs associated with selling its goods and services. It is sometimes shown as a dollar figure or can also be calculated as a percentage of sales. The higher the percentage or dollar amount, the better a business can meet all of its other obligations.
Example. If a business reports $500,000 in revenue and its cost of goods sold is $300,000, its gross margin is $200,000. The percentage is calculated by taking the gross margin of $200,000 and dividing it by sales of $500,000 to get the amount of 40%. This indicates that the business has 40 cents for every dollar of revenue. These funds can be used to pay expenses incurred from other obligations.
Industries vary. The amount of gross margin can also vary significantly between industries. For example, in an industry where most of the expenses are a result of the cost of goods sold, gross margin will be a lower figure. However, if a business incurs a significant amount of expenses apart from its cost of goods sold, its gross margin level must be higher in order to make a profit.
Why is it important to calculate gross margin?
According to the U.S. Small Business Association, many business owners fail to recognize the significance of knowing their gross margin. This is especially true of new business owners or startups that may not have the financial experience to accurately evaluate profitability.
Profitability. Knowing gross margin is essential in assessing your company’s profitability. As stated previously, calculating gross margin lets you know how much of profit you’ve got in order to meet obligations other than those related to your products and services.
Save money. You may want to take calculating gross margin a step further by evaluating it on a per product basis. This can help you determine if higher cost materials have been incorporated into production. Perhaps too much time or labor is being spent on a particular product. Having this essential information can help you make decisions that will keep costs lower down the road.
In other words, knowing your per-product costs and gross margin can help you control costs. Your gross margin may indicate a need to use materials at a lower cost. Maybe you need to create a more efficient production process so that labor costs are at a minimum. By keeping costs lower, the gross margin will increase and fewer products or services will need to be sold to break even.
Break-even point. Calculating gross margin is also a key element to knowing your company’s break-even point. Your break-even point tells you the amount of revenue you must make in order for your business to meet all of its obligations.
For example, if your expenses (not related to the cost of goods sold) total $100,000 and your estimated gross margin is 50%, your business would need to make $200,000 in order to cover all of its costs and break even.
Gross margin and pricing issues
There is another important reason for knowing your gross margin. It can help you pinpoint any pricing issues that may exist.
Pricing issues exist if a company charges too much or too little for its products or services, as either scenario can prevent it from making a profit. Pricing items too high might deter your average customer. Pricing services or products too low, in hopes of obtaining more customers, is a strategy that might work against you, too.
Businesses are sometimes tempted to “undercut” the competition by charging less. This could end up costing them as without the right analysis, a business could charge too little to end up not making a profit at all. It could also keep them from raising prices in the future as customers could react negatively to any price increases down the road, regardless of how long they have been your customer.
In summary, calculating as well as understanding gross margin can make a significant impact on your evaluation of the health of your business. It helps you know how much you need to break even. It helps you set a realistic, profitable pricing structure. It helps you determine how much money you have to meet other operating expenses.
Knowing your gross margin helps your business maintain profitability and avoid future risk.