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When evaluating the profitability of your small business, there are three main margin ratios to look at: gross, operating, and net. These ratios are listed in different sections of your business’s income statement. If you do not pay strict attention to these ratios, you will not fully grasp how well your business is performing. Gross margin, also referred to as gross profit margin or gross margin ratio, is one of small business owners’ most overlooked financial indicators. Still, it is also one of the most important.
In this Balboa Capital blog article, we dive deep into gross margin. You will learn what it is, how it is calculated, and how it can help you avoid problems relating to your pricing structure to remain profitable.
What is gross margin?
Gross margin is the amount of money your small business has after you subtract your cost of goods sold (COGS) from your net sales for a particular time frame. It is the percentage of your revenue that you keep after subtracting direct expenses like materials, supplies, and labor. The goal is to have the highest gross margin possible, which helps you meet (or exceed) your breakeven point.
A high margin also translates into more business revenue and more profit. Having more income allows you to boost your savings, maintain strong cash flow, and have money to cover the costs of your everyday operating expenses. In addition, keeping solid revenues and profits can help you weather unexpected financial storms or emergencies that might occur in the future.
How to calculate gross margin.
Now that you have a better understanding of a gross margin, let us explain how to calculate it. It is simple to do so long as you have an up-to-date and accurate business income statement. First, choose a period you want to evaluate, such as a month, quarter, or year. Next, look at the COGS for the same period. Finally, you need to subtract your COGS from your total revenue, divide the number by your revenue, and multiply it by 100. Doing so will give you a gross margin percentage.
Gross margin formula:
Total Revenue – COGS ÷ Total Revenue x 100
Let us assume you own an ice cream shop, and your total revenue last quarter was $55,000. Your COGS for the quarter was $39,000. To calculate your margin for the quarter, you simply subtract your COGS from your revenue ($55,000 – $39,000 = $16,000) and multiply the result ($16,000) x 100. In this example, your gross margin percentage is 16%.
What is a good margin?
Every industry is different, as is every small business, so gross margins vary widely. Grocery stores, car dealers, and furniture stores, for example, have lower margins than accounting firms, coffee shops, and storage facilities. Many factors influence margins in each industry, such as consumer demand and the costs of materials, labor, production, shipping, and storage.
Most accountants and business analysts agree that a 5-20% gross margin is something to strive for. However, remember that a seemingly low margin might be high in your particular business industry. For example, if your business’s margin is 6% and the average for your sector is 4%, you outperform your industry.
Putting it to use.
After you calculate your gross margin and compare it to the industry average, you will identify potential problems with your prices. For example, if you exceed your sales goals monthly but show minimal profits, your prices might be too low. The most successful small businesses have a good pricing strategy in place, which is not too low and not too high and that consumers see as worth their hard-earned dollars.
Next, your gross margin might also reveal that you are spending too much on the goods and products your business sells. When the costs of materials, production, shipping, and direct labor increase, your margin will decrease. So, be watchful of your COGS and make the necessary cost-control changes, if needed.
Lastly, you can also calculate the gross margin of the individual goods, products, and services you sell. Again, this is an intelligent business strategy because it lets you see which of your goods, products, and services are in high demand and which ones should take a back seat in your marketing efforts or slowly be phased out.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.