What is gross margin?
Gross profit margin, also known as gross margin, is a financial metric used to measure just how effective and efficient a business is at managing its operations. The gross margin is the sales revenue that a company retains after incurring the direct costs that are associated with producing the goods it sells and services it provides.
Gross margin helps to indicate the performance of a company’s sales based on the efficiency of its production process. The financial ratio is used by managers to assess and determine the efficiency of the production process for a product or service sold by the company, and is based on the company’s cost of goods sold.
Key takeaways from this section:
- Gross margin is a valuable financial measurement that helps to indicate the efficiency with which the business can produce and sell their products or services.
- Gross margin is based on the company’s cost of goods sold – the direct costs of producing the company’s products or services.
- The gross profit margin is a measurement that is highly valued by managers and also potential investors of a company as it is an accurate way of calculating business efficiency.
- The gross margin shows the amount of profit made before deducting selling, general and any admin costs.
Understanding gross profit margin
Understanding how to use gross profit margin is about monitoring it over time for unexpected changes and fluctuations. If a gross profit margin is going up and down between periods, it might indicate a problem with the product or its production, or management issues within the company.
However, sometimes it’s natural for gross profit margin to fluctuate if a company is making operational changes or significant investments. If a manufacturer invested in new, more efficient, machinery, this would likely reduce production costs and therefore increase the gross profit margin. Seasonality could also affect profit margins over time, but this should be anticipated and accounted for in an established business.
Changes in pricing or introducing new products will also affect gross profit margin, but these fluctuations can also be anticipated and accounted for, and won’t necessarily mean financial problems when the profit margin decreases.
How does gross margin work?
How to calculate gross profit margin
To find the gross profit margin of a company, the cost of goods sold (the direct cost of manufacturing a product) must be subtracted from the net revenue of product sales. This number is then divided by net sales and multiplied by 100 to give a percentage.
The higher the percentage, the more cash a company has to cover the other costs of running a business outside of the direct costs of creating a product or service.
An example of gross profit margin
One of the main uses of gross profit margin is to compare a business model with a competitor. If Company Alpha and Company Omega both manufacture mirrors with similar levels of quality and price points, but Alpha’s production costs are half what Omega’s are, Alpha will show a higher gross profit margin. This demonstrates that Alpha has a competitive advantage over Omega, and Omega needs to reconsider its production techniques or management practices.
The formula for calculating gross margin
Gross margin = (Net Sales – Cost of Goods Sold) / Net Sales
This formula will give a percentage which is the company’s gross profit margin.
The calculation for gross margin contains only two variables: net sales and cost of goods sold, both of which can be found on the company’s bank statement.
Net sales is used instead of total revenue as total revenue would not give an accurate answer if used in the above equation, as it does not subtract any returns, discounts or allowances from the total amount of sales.
Cost of goods is the sum of the overall production costs of a company’s product, and includes both direct labour costs and also any costs of the materials and resources used in the production and manufacturing of a company’s products.
What is the difference between gross margin and net margin?
Gross margin and net margin are both profitability ratios that are used to assess the overall financial wellbeing of a company. They are both expressed in percentage terms and are a way of measuring profitability as compared to revenue for a specific period.
Gross margin is the amount and proportion of money that is left over from revenues after accounting for the overall cost of goods that were sold. Net margin is the percentage of net income that is generated from a company’s revenue and is often referred to as the bottom line for a company, or the net profit.
Gross Margin FAQs
What exactly is gross margin?
Gross margin is a company’s net sales revenue minus the cost of goods that are sold. In other words, it measures the actual sales revenue retained by a company after incurring any direct costs that are associated with producing the goods that it sells and the services it provides.
How do you calculate gross margin?
The formula for calculating gross margin is Gross Margin = Net Sales – COGS.
Net sales is equivalent to the total amount of money that is generated from sales for the specific time period and includes all discounts and deductions from returned merchandise.
COGS is the cost of goods sold and includes both direct labour costs and also any costs of materials that were used in the production of the company’s products.
What does gross profit margin tell you?
Gross profit margin is an indicator of financial health when it comes to the production and sale of goods. It can show if manufacturing costs are too high or sales are poor, and highlight operational or management problems negatively affecting a business.
What is a good gross profit margin?
This will be different across different industries, but in general a profit margin of around 10% is healthy, while 20% would be considered high, and 5% would be considered low.
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