Gross Margin is a company's net sales revenue minus its cost of goods sold (COGS). In other words, it is the sales revenue a company retains after incurring the direct costs associated with producing the goods it sells, and the services it provides. The higher the gross margin, the more capital a company retains on each dollar of sales, which it can then use to pay other costs or satisfy debt obligations. The net sales figure is simply gross revenue, less the returns, allowances, and discounts.
Gross Margin is an indicator of whether a company is running an efficient operation and if its sales are good enough. Gross Margin is also known as Gross Profit Margin. However, the term “Profit Margin” by itself may refer to any of the following margins:
- Operating Profit Margin
- Pre-Tax Profit Margin
- Net Profit Margin
Each of these profit margins weigh the cost of doing business with or without certain costs factors. For instance, operating profit margin is calculated without interest or tax, while net profit margin considers all expenses related to the production of a product (it’s also known as “the bottom line”).
Gross Margin Can be an Amount or an Expense
Gross margin could be expressed as:
- An amount (also known as gross profit)
- A percentage of net sales (also known as gross profit percentage or gross margin ratio)
The gross margin may be calculated for an individual product, a product line, or for the entire company.
Percentage margins and unit margins
Gross margin can be expressed as a percentage or in total financial terms. If the latter, it can be reported on a per-unit basis or on a per-period basis for a business.
"Margin (on sales) is the difference between selling price and cost. This difference is typically expressed either as a percentage of selling price or on a per-unit basis. Managers need to know margins for almost all marketing decisions. Margins represent a key factor in pricing, return on marketing spending, earnings forecasts, and analyses of customer profitability." In a survey of nearly 200 senior marketing managers, 78 percent responded that they found the "margin %" metric very useful while 65 percent found "unit margin" very useful. "A fundamental variation in the way people talk about margins lies in the difference between percentage margins and unit margins on sales. The difference is easy to reconcile, and managers should be able to switch back and forth between the two."
Importance of understanding gross margin
Your gross margin can tell you a number of things. It can show you that your COGS is too high, pricing is too low, or offerings need an update or change.
Many business owners fail to recognize the significance of their gross margin, especially new startup owners that don’t have as much financial experience.
Calculating your business’s gross margin can help you:
- Evaluate profitability
- Save money
- Determine your break-even point
Knowing your business’s gross margin is essential in assessing your profitability. Calculating gross margin lets you see how much profit you make after you factor in your cost of goods sold. Without your gross margin, you wouldn’t know how profitable your business is and whether or not you need to make adjustments to prices or direct costs.
If you’re looking to save money, your gross margin can help. As you saw in one example, you can calculate gross margin on a per-product basis. Calculating gross margin can show you if you’re spending too much time or labor on a certain product or service. Having your gross margin can help you make decisions that will keep your costs lower and improve your profits in the long run.
To know your company’s break-even point, utilize your gross margin. Your break-even point is the amount of revenue you need to earn in order for your total sales to equal total expenses. For example, if your business expenses total $50,000 and your gross margin is 50%, you would need to make $100,000 to cover your costs and break even.
- Definition - What Does Gross Margin Mean? Invetopedia
- Explaining Gross Margin Freshbooks
- Gross Margin Can be an Amount or an Expense Accounting Coach
- Percentage margins and unit margins Wikipedia
- Importance of understanding gross margin [patriotsoftware.com/blog/accounting/what-is-gross-margin/ Patriot]