Gross Margin: Definition, Calculation, and Tips for Improvement

As a small business owner, we know that keeping track of and understanding several financial metrics may feel overwhelming. But gross margin, sometimes called gross profit margin, is one of the simplest and most important metrics you can use to gain insight into your business’s efficiency. If you understand the gross margin meaning, you can better determine how to increase profitability and leverage it to grow your business. Keep reading as we walk through this important metric, including how to calculate gross margin and how to improve gross margin for your small business.

What is gross margin?

So, what is gross margin exactly? Gross margin refers to the amount of money a small business retains after the direct cost of producing the goods or services is subtracted from the revenue earned. It’s generally expressed as a percentage. Gross margin looks at a business’s gross profit compared to its revenue or sales. In other words, it shows the ratio of direct expenses to profits.

Understanding and monitoring your business’ progress using the gross profit margin formula is crucial as it:

• Is an indicator of your business’s profitability: A higher gross margin means your business is efficient turning sales into profit.
• Helps with cost management: Understanding this topic helps you keep an eye on your production and operation costs so you can find areas where you can cut costs without harming quality.
• Gives insight into your pricing strategy: Your gross margin can help you determine if your pricing strategy is effective. A lower gross margin percent may mean it’s time to reevaluate your pricing or cut costs.
• Can give your business a competitive advantage: Stay competitive in your market by comparing your gross margin to industry benchmarks.
• Is an indicator of your business’s financial health: Get insight into your business’s financial stability and overall well-being.
• Helps with strategic planning: Gross margin helps you make data-driven decisions and focus on profitability.

Gross margin vs gross profit

Now, let’s examine gross margin vs. gross profit. Yes, there really a difference between these two terms. Admittedly, gross profit and gross margins are similar business terms but not completely the same.

Gross profit is the amount of money a business makes from its sales after subtracting the costs directly related to producing or delivering the goods or services.

Gross margin is a percentage that shows how much of each dollar of revenue a company retains as gross profit. It’s a measure of the profitability of a company in relation to its revenue.

How to calculate gross margin

Before we dive into calculating gross margin, let’s clarify gross margin vs. gross profit as it’s easy to mix up their formulas. As mentioned above, gross margin is a measure of profitability that’s expressed as a percentage. Gross profit (GP), on the other hand, is expressed as a hard dollar figure. Gross profit gives insight into how much money a company earns after factoring in production and sales costs. Gross profit is calculated by using the following formula:

GP = net sales – cost of goods sold

Bookkeepers and accountants will generally write a company’s gross margin as a percentage. However, if they want to express it in a dollar amount, they’ll use gross profit instead. To calculate gross profit margin use this formula:

Gross profit margin formula

For the gross margin formula, you need two key pieces of information: total revenue and cost of goods sold (COGS). You’ll notice that these are the same pieces of information needed for gross profit as well.

• Total revenue or net sales: Total revenue is a fancy way of saying the total money made from selling a product or service.
• Cost of goods sold (COGS): This is the direct cost of producing goods. It includes labor costs and any materials expenses to produce a product.

The gross margin formula is:

Gross margin = [Gross Profit / (net sales) ] x 100 = [(net sales – COGS) / (net sales) ] x 100

Gross margin calculation

Here’s how to calculate gross margin step-by-step using the formula above. We’ll be reviewing calculation steps using Sarah’s Bakery as an example.

1. Calculate net sales – First, Sarah must determine her bakery’s net sales. Net sales is total revenue minus any money lost on returns, discounts, and allowances. Sarah finds this information on her income statement. Sarah’s Bakery’s net sales from purchases of her cookies, scones, and other baked goods, after factoring in returns, discounts, and allowances, are $120,000.

2. Find the cost of goods sold – Cost of goods sold (COGS) are direct costs a business pays to produce and sell their products or services. Direct costs include both direct labor expenses and costs of materials used to manufacture or produce products. Sarah’s COGS for her bakery include things like butter, sugar, and flour. Her COGS total to $45,000 for the year.

3. Use the gross margin formula – Once Sarah knows her net sales and COGS, she uses the formula to calculate her gross margin.

Sarah’s Bakery’s gross margin = [($120,000 – $45,000) / ($120,000) ] x 100 = [($75,000) / ($120,000) ] x 100 = 62.5%

Sarah’s bakery’s gross margin calculation yielded 62.5%. Functionally, this means that for every one dollar Sarah’s company earned, 62.5 cents was retained as gross profits. Keep in mind that this does not account for expenses like rent, utilities, and salaries.

What is a good gross profit margin?

Gross margin can be used to compare performance across periods to determine if the business is performing consistently and to meet performance goals. But is a high gross profit margin always better than a low gross profit margin?

What makes a “good” or “bad” gross margin largely depends on the industry your business operates in. A higher gross profit margin is generally seen as favorable in most industries. In indicates more potential for overall profitability and higher net profit margins.

But remember, service based companies and product based companies gross profit margins usually look significantly different. Since product focused businesses must pay to produce a physical good, their gross profit margins are often much lower than service based companies who don’t have product costs in the same way.

So, now that we’ve explained what gross margin is, let’s discuss how to know if YOUR company has a good gross margin.

• Good gross margin: You have a larger gross margin if your cost of goods sold is high and your expenses are low. Note: Service-based industries like realtors and childcare providers tend to have higher gross margins because operating costs are minimal.
• Low gross margin: If you see your gross margin falling, it may be because your expenses are overtaking your profits. Some industries, especially product-driven ones, operate on a small margin. For example, common low gross-margin business includes manufacturing, retail, and transportation/logistics.

Higher gross profit margins are nearly always desirable. The higher your operating margins, the higher your net profit. But it is wise to compare your company’s gross margin figures to industry benchmarks to get a good point of comparison versus your peers and competitors.

Gross margin benchmarks by industry

What is a good gross profit margin? As mentioned above, it depends on your industry. Here are a few recent gross margin benchmarks by industry from Ready Ratios to consider:

• Business Services: ~57%
• Educational Services: ~52%
• Insurance Agents: ~47%
• Furniture and Fixtures: ~38%
• Retail: ~37%
• Eating & Drinking Establishments: ~32%
• Food Stores: ~28%
• Building Construction: ~24%
• Transportation Equipment: ~17%
• Wholesale, non-durable goods: ~17%
• Agriculture, livestock: ~15%

As you can see, companies that earn money through services tend to have higher profit margins than businesses that sell products.

Tips for improving your gross margin

Improving your gross profit margin is an important way you can sustain growth as you build a successful business. Here are a few tips to help you increase your gross profit margin and enhance overall profitability:

Analyze and optimize pricing

Strategic pricing is one of the most effective ways to improve your gross profit margin. Regularly analyze your pricing structure to align with market demand. Make sure you understand how you stack up against your competition. Are you try For example, value-based pricing is one pricing strategy where prices are based on the perceived customer value of products or services. Additionally, monitor pricing trends and adjust prices when necessary to maximize profitability.

Reduce COGS

The cost of goods sold directly impacts your gross profit margin. So, keeping close tabs on your business’ COGS is critical. To reduce cost of goods sold, consider negotiating better supplier deals. Can you secure a bulk discount or use an alternative supplier? Evaluate every link of your supply chain to find cost savings.

Decrease labor costs

Reduce labor costs by training your employees to be more efficient. Well-trained workers can get more done in less time. You may even reward them for sharing ideas that could save the company money. Engaging your employees can also improve their job satisfaction. This is a way to decrease labor expenses too. Focusing on employee retention reduces turnover costs – hiring new employees is expensive and time consuming.

Increase sales

One way to increase sales is to look at your sales funnel. Consider how you might optimize your sales process to increase revenue. Boosting sales volume can positively impact your gross profit margin. Expanding your customer base through marketing efforts is one way to do this. For example you might offer promotions, bundle products or services, or explore cross-selling and upselling opportunities.

Manage overhead costs

While controlling COGS is crucial, it is equally important to manage overhead costs effectively by routinely reviewing these expenses. Identify areas to cut unnecessary expenses. Negotiate better rates with service providers. Seek alternative solutions which will reduce your expenses while maintaining the quality of your product or service. Implementing cost-saving measures can significantly contribute to growing your gross profit margins.

Streamline operations

The efficiency of your small business impacts your profit margin. Seek ways to streamline processes, improve inventory management, reduce lead times, invest in technology, optimize resources, or eliminate unnecessary steps or job roles in your business. 

Shorten the sales cycle

Try strategies to make sales sooner. For example, you can improve your website’s FAQ section, implement a live chat, or create automated responses to speed up the customer acquisition funnel. Shortening the sales cycle on the production end is made possible by implementing technology or nixing unnecessary steps in the production process. This strategy is all about getting the customer to make the purchase decision more quickly, whether through information, technology, or another means.

Challenges in maintaining a high gross margin

While you work to maintain a high gross margin or improve your business’s profitability, there are challenges that may be out of your control. Common challenges to growing gross margin include:

• Rising costs of materials, labor, overhead, etc
• Increasing market competition and competitive pricing environments
• Regulatory changes (like new state laws, tax code changes, etc)
• Change and disruptions to market conditions
• Supply chain interruptions, delays, and shortages from natural disasters, geopolitical conflicts, etc
• Quality control when reducing COGS or increasing sales volume
• Operational shortcomings from outdates processes, old technology, employee turnover, etc.

Gross margin vs net margin vs operating margin

There are three main profit margin metrics: gross profit margin, operating profit margin, and net profit margin. It’s easy to get these metrics confused. After all, they all show how much money your business is retaining after certain expenses are deducted.

Remember, gross margin is only concerned with the relationship between revenue and cost of goods sold. Net profit margin is different from gross profit margin in that it refers to how much money your business makes after all expenses are removed. It takes into account every single business expense including COGS, operating expenses, interests, and taxes. Net margin is the percentage of net income earned from revenues received.

Operating profit margin is your business’s profit after subtracting cost of goods sold and operating expenses. Operating expenses are things like employee salaries, depreciation, and amortization.

How to leverage gross margin analysis for your small business

Analyzing your gross margin can be beneficial for your business. Aside from providing insight into your company’s financial well-being, gross margin analysis can give you a starting place to help improve your profitability. You can leverage gross margin analysis by making improvements that will lower your costs but increase revenue, identify financial areas to be improved, make well-informed pricing decisions, get a feel for your growth potential, and more.

Get more small business help: applying gross margin calculations

Calculating gross margin as a small business owner is crucial to understanding your business’s financial health and profitability. Whether your business is just getting started, or you’re a seasoned owner, Block Advisors is here to help. Get back to doing what you love and let our experts lighten your load, in person or virtually, year-round — as always — backed up by the Block Advisors guarantees. Our taxes, bookkeeping, payroll, and incorporation services are designed with small business owners like you in mind.

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This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice.