Katherine Gustafson is an author and personal finance expert from Portland, Oregon. She writes about investing for Wealthsimple as well as having written for Forbes, Business Insider, TechCrunch, and LendingTree. Katherine is a past recipient of the Izzy Award for outstanding achievement in independent media. She has a BA from Amherst College and an MA from Boston University.
The word “gross” has negative connotations, but in business it’s generally much more neutral, if not positive.
Consider the term “gross margin,” which refers to how efficiently a business turns the money it brings in the door into profit for its owners and shareholders. Nothing negative about that.
Let’s dissect the topic of gross margin so you can understand how to use this important business tool, or at least so you can name-drop it at parties, such as by responding to “how’s business?” with “our gross margin is solid.”Finances can be complicated, we make them simple. And offer low fees and friendly financial advice along the way. Use our state of the art technology to get started investing.
What is gross margin?
A business generates revenue when its sells products or services to customers. The gross margin is the percentage of total revenue that remains after accounting for the expenses directly related to creating the goods to be sold. If you’re a baker whose loaves of bread sell for $2 and cost $1 to make, accounting for ingredients and labor time, then you have a gross margin of 50%.
As with the baker, some of a business’s revenue pays for the process of making the product or delivering the service. This is known as the cost of goods sold, or COGS, which includes the expenses directly related to creating the goods, such as materials and labor costs for production, but excludes indirect costs like administrative expenses and rent payments. Whatever revenue is left over after you pay for the COGS is known as gross profit.
The greater the gross margin the better. That’s because a greater gross margin indicates a smaller difference between total revenue and gross profit—that is, more revenue can be kept to pay for other aspects of the business and generate net profits.
You get a higher gross margin when the cost of producing goods or services is low, whether that’s because they are cheap to produce, the company’s operations are efficient, or sales are robust enough to allow for economies of scale.
Service-based businesses tend to have higher gross margins than businesses that sell products because service providers don’t have to shoulder the expense of manufacturing. And it’s normal for early-stage startups to have low or variable gross margins, since establishing efficient operations can take time.
Gross margin vs. gross profit
Many people use the terms gross margin and gross profit interchangeably, but these terms are distinct. They do refer to the same thing—how much of a business’s revenue is available for use after making the products—but gross margin is expressed as a percentage while gross profit is expressed as a dollar amount.
Gross margin is a more useful figure for comparing businesses to each other, because it reflects the relative efficiency with which a business produces its goods irrespective of its amount of profit as a dollar amount.
For example, an established company with $1 million in annual revenue may have a lower gross margin than a lean startup that brings in $400,000. If the large company’s COGS is $475,000, its gross profit is $525,000, and its gross margin is 52.5%. Meanwhile, if the startup’s COGS is $160,000, its gross profit is $240,000, and its gross margin is 60%.
The established company must maintain a larger infrastructure and more staff to create the products that generate its revenue. So while it brings in more money than the startup, to do so it has to spend more relative to its amount of gross profit than the smaller fish does.
How to calculate gross margin
Figuring out your gross margin is straightforward; you just need to know your company’s revenue and COGS. First, calculate gross profit by subtracting the COGS from the revenue:
Gross Profit = Revenue – Cost of Goods Sold
After you’ve figured out your profit figure in dollars, turn that into gross margin by calculating the percentage of revenue it comprises:
Gross Margin = Gross Profit / Revenue x 100
Put another way:
Gross Margin = (Revenue – Cost of Goods Sold) / Revenue x 100
Let’s look at the example of a small company that manufactures computer cables and brings in $500,000 in annual revenue. The cost of creating the cables includes materials, labor, and other inputs into manufacturing. Those direct costs are the COGS, which total $200,000 for the year.
To find the gross profit, the founder plugs the company’s numbers into this equation:
$500,000 – $200,000 = $300,000 (Revenue – Cost of Goods Sold = Gross Profit)
Next, to find gross margin, the founder uses this equation:
$300,000 / $500,000 x 100 = 60% (Gross Profit / Revenue x 100 = Gross Margin)
This computer cable maker is doing well; consumer electronics companies with gross margins higher than 50% are in a good position for growth and may have little need for outside investment, according to manufacturing support company Dragon Innovation.
Gross margin vs. net margin
Gross margin may reflect the percentage of revenue that winds up as profit after you account for the COGS, but that isn’t the final picture of your business’ profits. After all, there are many indirect costs to account for: rent, utilities, office equipment, administration, marketing, salaries and benefits for support staff, interest on debt, taxes, and on and on.
Net profit is whatever revenue is left after also paying for all these indirect costs. And net margin is the percentage of revenue that winds up as profit after you account for the totality of the business’ expenses during the given time period. The finality of this number is why the term “profit margin” is usually used to refer to net profit margin, not gross profit margin.
Gross margin is directly related to net margin because the larger the gross margin, the more the company has to invest in R&D, sales, marketing, and other functions that may make the key difference for success in the market. And success in the market means higher net margins as investors recoup a healthy percentage of revenue as profit.
While you may expect gross margins to be high—for instance, the cable manufacturer’s is 60%—net margins are for obvious reasons much lower. A net margin of somewhere around 10% is considered average, and 15% is good. None of the 15 most profitable industries in 2016 clocked a net margin over 19%, according to Inc.
What does gross margin tell you?
Gross margin is a useful figure because it gives you a sense of how efficiently your company is able to produce its goods and services. It tells you if you are more or less efficient than your competitors, and allows you to assess your company’s financial health and whether you might need to seek outside investment.
You can track your gross margin over time to see if your processes are getting more or less efficient or to assess how certain changes in your business or industry, such as a new product launch or new regulations, are affecting your efficiency.
Gross margin also provides a motivating red flag when you come up short. If you find your gross margin is lower than you’d like—or, importantly, lower than your competitors’—you can analyze your COGS to see where you can improve your sourcing or manufacturing process to cut costs. Because gross margin isolates only the costs directly related to producing products, you can see exactly what physical elements go into your goods and what those elements cost.
Tread carefully when comparing your gross margins to others, however. While it is always an extremely useful figure for assessing changes in your company’s manufacturing efficiency, it’s only useful as a point of comparison with others if they are in your own industry, and ideally a close competitor. Gross margin is less useful to compare companies in different sectors, since production processes vary extremely widely across industries.
For example, it makes no sense to compare the gross margin of the computer cable company with the gross margin of a consultant who has little overhead and no manufacturing process. The consultant’s gross margin is sure to be far higher than the cable company’s—potentially close to 100%. The cable company and the consultant are like apples and oranges; they have completely different ways of serving their customers. Comparing them tells you little.
High gross margins in the context of your industry indicate a strong and efficient company. It is an important element in an assessment of a company’s financial health. However, it is only one factor. There is a far bigger picture to look at in determining whether a company is truly healthy.
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