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 company’s income statement. If you do not pay strict attention to these ratios, you will not be able to fully grasp how well your business is performing.
Gross margin, also referred to as gross profit margin or gross margin ratio, is one of the most overlooked ratios by small business owners, but 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 so you can 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. In a nutshell, 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 gross margin also translates into more business revenue and more profit. Having more revenue allows you to boost your savings, maintain strong cash flow, and have money to cover the costs of your everyday operating expenses. Of course, maintaining strong revenues and profits can help you weather unexpected financial storms that might occur in the future.
How to calculate gross margin.
Now that you have a better understanding of what a gross margin is, let us explain how to calculate it. This is simple to do, so long as you have an up-to-date and accurate business income statement. To get started, choose a time period that you want to evaluate, such as a month, quarter, or year, and look at your total revenue for the period. Next, look at the COGS for the same period. You then need to subtract your COGS from your total revenue, divide the number by your revenue, and multiply it by 100. This 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 gross 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 gross margin?
Every industry is different, as is every small business, so gross margins can vary widely. Grocery stores, car dealers and furniture stores, for example, have lower margins than accounting firms, coffee shops and storage facilities. Reason being, there are a multitude of factors that influence margins in each industry, such as consumer demand and the costs associated with materials, labor, production, shipping and storage.
Most accountants and business analysts agree that a gross margin of 5-20% is something to strive for. Keep in mind that a seemingly low gross margin might actually be a high gross margin in your particular business industry. For example, if your company’s margin is 6% and the average for your industry is 4%, you are outperforming your industry.
Putting your gross margin to use.
After you calculate your company’s gross margin, and comparing it to your industry average, you will be able to identify potential problems with your prices. If you are exceeding your sales goals on a monthly basis but posting minimal profits, your prices might be too low. The most successful small businesses have a good pricing strategy in place, one that is not too low and not too high, and that consumers see as worth their hard-earned dollar.
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. This is a smart business strategy because it enables you to 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.