Nothing to do with margins that make you feel queasy, “gross margin” is simply the portion of a company’s revenue that’s left over once direct costs are taken away. You’ll find it expressed as a percentage.
Direct costs could cover anything from raw materials to labour, stock, packaging and equipment.
We sometimes get asked about the difference between gross margin and gross profit margin. Answer: Nothing. They’re the same thing.
A higher gross margin means a business retains more capital after it’s paid for all the essentials that keep it running. Capital means money which usually means growth or at least sustainability, but aren’t we already calculating revenue and profit? Why should we bring gross profit margins into the equation, too? Won’t my brain explode if I stuff it with more numbers?
Maybe, but margin is an important measure of profitability. For every item, product, hour or unit you sell, having a viable margin ensures your business is sustainable.
Let’s illustrate this with an example. Meet Umbrellievable Ltd. — they sell umbrellas.
They buy an umbrella for $50 and sell it for $100. This makes their gross margin $50 ($100 minus $50). That’s a 50% gross margin.
Let’s say inflation hits the umbrella industry and now each umbrella costs $55, but Umbrellievable Ltd. didn’t increase their prices. Their margin is now $45 and 45%. It’s decreased by 5%.
They could just increase their sales price by $5 and charge $105 for their umbrellas. Now the margin is $50 again but has only increased by 47.6%. That’s because the umbrella cost increased by 10% for the business, but they only increased their sales price by 5%. If they forgot to calculate gross profit margin, they probably wouldn’t notice that (or understand why their profits are being washed away.)
You can calculate gross margin with a simple formula:
GROSS PROFIT÷ REVENUE X 100%
Your gross profit is found by taking away the cost of goods sold or the cost of sales from your revenue.
Just don’t forget about GST. Before you stab away at that calculator, we recommend pricing your products without GST. That’s mostly because GST goes to the IRD anyway, so you can keep your accounting consistent by ignoring this while you calculate expenses, margins and all that jazz.
Is your gross margin a good one or should you be hitting the panic button? It’s hard to give a clear-cut answer. Average gross margins vary depending on the typical expenses for businesses in your industry. Businesses that require lots of labour and raw materials, for example, usually have lower gross margins.
That doesn’t mean they’re faring any less well. The best way to evaluate the health of your gross margin is by comparing it to that of similar companies. If you find yourself below the benchmark, it’s worth investigating how things could be better.
Check up on your gross margin regularly so you can make fast decisions at key times.
So many businesses go about their day-to-day sales without paying attention to gross margin. Which means they can’t understand if they’re making good enough margins or even a consistent profit. Not a good move when you’ve got your eye on long-term success.
Don’t follow the crowd. Follow BOM instead. We’re way cooler.