Gross Margin Explained
One of the most important performance numbers is the gross margin. The gross margin is calculated by taking a company’s gross profit and dividing it by total sales. Gross profit is the highest profit number on an income statement and is calculated by taking the total sales and subtracting cost of goods sold (the costs of purchasing or producing the items or services sold). In other words, gross profit assesses how much is earned on the products and services sold by the company. Gross margin, looks at the percentage of sales that this accounts for.
Suppose you have a company that sells widgets. It costs you $8 to manufacture each widget and you sell the widget for $10. Your gross profit is $2. Analyzing your company’s income statement to determine whether or not $2 is a sufficient gross profit number is only partially useful. Now, if you calculate the gross margin, you will discover that on widgets, you produce gross margins of 20 percent. That number can be compared to the gross margins of other products you sell as well as similar products sold at competitor companies. If your margins are too low, you can now consider strategies to improve them.
For example, low gross margins could mean that you are pricing your products too low. If you increased the sale price from $10 to $12, you now generate a gross profit of $4 and gross margin 33 percent. Not bad! Of course, you have to make sure that you don’t lose customers by raising your price. You could also look at ways to reduce the cost or producing or purchasing your products. Perhaps there is a ways to lower the cost from $8 to $6. This would raise your gross profit to $4 and your gross margin to 40 percent assuming you maintained a sale price of $10. Gross margin is not only a good way to assess perform but a good way to help optimize pricing and cost.
Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com .