What You Need to Know About Gross Margins - Accounting 101
Do you need a way to find out the profitability of a specific product or service? Use Gross Margin. This formula is expressed in percentage, and it helps to determine how much you will earn after deducting the cost of producing and selling your products and/or services.
The Gross Margin Formula
Gross Margin = (Revenue - Cost of Goods Sold ) / Revenue
This formula is straightforward to remember and easy to apply. Deduct your revenue with the cost of making your product and divide the result with the revenue again. If you want to, you can multiply the result with 100 to give yourself a percentage, e.g., 0.50 to 50%.
For example, imagine you have a revenue of $100,000. That is a lot, but you know that it cost $40,000 to make the products. Plug in the numbers appropriately. $100,000 minus $40,000 will give you $60,000. Now, take that $60,000 and divide it by the revenue, which is $100,000. This will give you a percentage value of 0.6, or 60%.
You can conclude that at the gross margin of 60%, you earn six cents for every dollar. This means that the business is making more profit than the cost of producing or providing the product or service.
Gross Margin Vs. Gross Profit: What is the Difference?
Gross profit is essentially the same as gross margin, but not in percentage values. Gross profit expresses the end result as a total dollar amount. It is a simple case of revenue deducted by the cost of goods sold. Using the example above, you get a gross profit of $60,000.
Gross Margin: Why Does it Matter?
Knowing the gross margin will help you determine if you can generate a profit. It also provides a foundation to understand how efficient your business is in the production and selling of a product or service, and the profitability of that sold item. Comparing past years’ gross margin can help you determine if any improvement is to be done.
If there is any improvement to be done, the easiest method to use is to increase the price of your product or service directly. However, this comes with risks. Many business owners fear that an increase in prices will dissatisfy their customers. Before you use this approach, you must do your research.
Look at your competitors and what prices they’re charging. If you do want to raise your prices, make sure your customers will see that your product is still worth their money. Another way to improve your gross margin is to lower your COGS (cost of goods sold). Look for a supplier that provides the same or similar items at a lower cost. If they offer discounts when purchasing in bulk, use them to your advantage. It is much harder for you to lower your COGS than it is to raise your prices, but your customers will surely be happier.
However, as a whole, you shouldn’t only focus on gross margin as a measurement for your business’ performance. Many professional investors look at other aspects, such as profits and operating expenses, to know the full picture, and you should do the same, as this will give you a much broader understanding of the status of your business.
Do yourself and your business a favor and learn about gross margins. It is one of many ways to help you determine if you need to improve your company, or if you’re on the right path.
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