Gross margin

Gross margin is a coefficient that determines how profitable sales are. Let’s look at examples: why you need to calculate this indicator, how to increase it, and what disadvantages it has. 

Gross margin: what it shows

If you translate gross margin, it will turn out to be gross profit. True, this is not entirely true. Profit is what is left after deducting the cost from revenue, and the margin from the level of sales.

Gross margin helps to achieve the following goals:

• Ease of definition for any business. If the company is small, and the costs are almost constant, it is quite easy to determine the profitability of its work. In this case, it is possible to take into account the costs. If there is their dependence on some specific conditions, the same seasonality factor, expenses are divided into a bunch of subgroups, and the business is directly related to third-party investments – your solution is gross margin. It is this ratio that will make it possible to give a key assessment of the company’s efficiency.
• Sometimes a net profit is not a guarantee that things are going well. For example, in situations where it goes to pay some bonuses, hospitality expenses, etc. 

Thus, the coefficient allows you to determine the amount of profit per unit, expressed in any currency, in the total mass of revenue.

Why do you need to calculate indicators

• setting the final price: the coefficient helps to determine the minimum possible and optimal value at which the business owner will make a profit;
• analysis of the activities of sales and purchasing managers;
• the ability to evaluate the logic of costs and optimize them.

Advantages and disadvantages of the ratio

The advantages of this method of determining the success of a case include:

1. Ease of calculations. The formula is elementary, and all the data for calculations can be found in the balance sheet.
2. High analysis speed. If you have margin indicators by industry, you will quickly determine the optimal indicator for the enterprise and will be able to understand how well pricing is built and how well the business is working.

Minuses:

1. The picture is far from complete. Having made the calculations, it is impossible to say with certainty whether things are going well or badly. The resulting value can give a reliable answer only in one case – if it is used together with the net profit margin.
2. Coefficient fluctuations do not always indicate an improvement or deterioration in the situation. Often they are temporary. For example, such a phenomenon occurs at the initial stage of enterprise development. At first, expenses are often higher than income, but this is not a reason to stop activities – if everything is done correctly, the situation will stabilize over time.

Where is the gross margin applied?

It manifests itself in the best way when preparing a macroeconomic analysis of a company or an entire industry. It is good to use it in a detailed examination of the country’s market.

To make the analysis as complete as possible, in addition to the gross margin, you need to use indicators of operating profit, as well as income-related to investments. This coefficient only signals how profitable the business is, without specifying where there are gaps and whether they can be somehow eliminated.

Gross margin is affected by the following factors:

• the level of sales or production of products;
• the quality of work of sales and purchasing managers;
• salary fund;
• equipment repair or purchase;
• fixed associated costs – such as renting premises and services of a security company.

That is, when calculating the coefficient, not only revenue is taken into account, but also costs, which cannot be waived in any way. Without them, the company will not be able to function. It is important that the ratio of income and expenses be verified – the volume of the gross margin depends on this.

Formula

GM= (Revenue –Cost) / Revenue ∗100%

where:

• Revenue — revenue;
• Cost – cost.

The following formula is used to calculate the cost:

Cost = Purchase Price + Direct expenses + Indirect expenses

where:

• Purchase Price — purchase price;
• Direct expenses – direct costs;
• Indirect expenses – indirect expenses.

At the same time, direct costs mean the purchase of raw materials, materials, salaries, depreciation, delivery of products, etc. Indirect costs are the rent of premises, marketing and a number of other permanent items.

Gross Margin Example

Given: 

• Purchase price = 4500
• Direct costs = 1200
• Indirect costs = 1400
• Revenue = 9000

In this case, the cost will be equal to: 4500 + 1200 + 1400 = 7100

Gross margin will be: = (9000 – 7100) / 9000 * 100% = 21.11%.

How to increase marginality

A quick and logical way is to increase the price of a product. True, not all business owners are ready to do this – many people think that because of this they may lose customers. But, in fact, not everyone will notice a rise in prices, if done wisely. Nobody says to increase the price by 50%, 3% is enough. You will be surprised, but even 3% of the price increases marginality by 15%.

Another logical way is to increase advertising budgets. But there is no point in this if you have not eliminated the gaps in the work of the sales department. Often managers are too lazy to process applications and quietly merge them. So what’s the point of raising marketing costs and attracting leads if the sales process is not built in any way. Only after debugging this process, it is worth starting to repackage the product.

Summarize

Gross margin is an indicator that helps to estimate the amount of profit in each earned ruble (dollar, euro, etc.). If you know how to and regularly calculate the gross margin, you can notice in time that the company has problems or, on the contrary, growth has begun. To make calculations, it is enough to obtain data from the financial statements. It is easy to determine the values, but not the last in importance for the company.