As a business owner you’ll already know that there’s a whole host of ways to measure profitability. One of these ways is to measure gross profit and your gross profit margins. Of course there are numerous methods and lots of figures you can use as an indicator but gross margin is very important. As a general rule, the higher it is, the healthier your business is so it’s a key factor in determining and managing your business’ health.
What is gross margin?
A gross profit margin is the difference between sales and the cost of goods sold divided by revenue. This represents the percentage of each pound of a company’s revenue available after accounting for cost of goods sold.
How do I calculate gross margin?
To calculate a gross margin simply add together sales and subtract costs of goods sold. To get a percentage of revenue simply divide by revenue (Gross Margin (%) = Revenue – Cost of Goods Sold/Revenue).
For example, if a business earns 32 million in sales but pays 24 million for the items sold, then the company’s GPM would be (32M – 24M) / $32M = 25 percent.
If you can cut costs as a business you can increase your profit margin. For example, if you sell a product for £500 and the cost of the producing the phone is £250, the current gross profit margin is 50 percent ((500-250)/500). If you can reduce production costs from £250 to £200, the GPM is 60 percent ((500-200)/500).
So to reiterate…
Gross margin is the calculation of how much it costs your company to get your product or service in to the customer’s hands taking away the cost of the goods or service. For hard goods this should include the cost of shipping to you and the costs that help you to keep the lights on at the business.
It is important to bear in mind however, that the calculations you take into account to find your business gross margin will vary from industry to industry and your company goal. This will also vary depending on whether you are selling a service or physical product.
Why is it important to know this by product / service?
By knowing the gross margin on all the products or services you sell you are better placed to price yours accurately within your market. Many businesses fail because their costs are too high and pricing is too low. Determining what your product or service is going to cost to be ready for sale is extremely important.
It’s also important to keep in the forefront of your mind that gross margins change. This can be due to increased or reduced costs and through increased or decreased inefficiencies throughout the company but by not paying attention to or ignoring these margins you are doing your business a disservice. A business’s gross margin is a great KPI of your company’s health.
What can you do to improve the gross profit margin?
As mentioned above, gross profit margins will vary from industry to industry and business to business. However, if your gross profit margin is not looking as healthy as you would like or as healthy as you need it to be you have two options: Increase your prices, or reduce your costs.
Increasing your prices might be the more appealing pathway, but it can also be a dangerous method if you do so without looking at your competitors and where they sit in the market. You don’t want to put potential customers off due to higher pricing. Here’s an example: if you spend £1000 on stock and sell it for £1200, you are making a gross profit of £200 and a gross profit margin of approximately 17%. You then decide that profit margin is adequate, so increase your pricing. If you buy the stock for 1000 but then sell it for £1500 successfully, this will improve your gross profit margin to 50%. However, the risk arises if you do not sell all your stock due to the increase of price. You potentially run the risk of going into negative gross profit which would defeat the purpose of the task. The answer may be to find a balance between the two, but this is why it’s important to analyse your business and your competitors.
Reducing your costs may not always be possible, however it’s a good idea to evaluate if there’s anywhere along the way you can save money. Maybe you can renegotiate the deal with your supplier, by reducing your stock purchase price from £1000 to £700 for example; you would increase your profit margin to around 70%. It’s important for you to look at both options, if there’s room for more on both sides then take advantage of the opportunity.
Gross profit and gross profit margins are an important evaluation technique for your business, if you think there might be room for improvement in your business but don’t know where to start then speak with one of our experts from our digital marketing agency Birmingham. Call us today on 0870 062 8760 or send us an email at at firstname.lastname@example.org to see how we can help increase your businesses gross margin.
If you enjoyed reading this article you may also like to read our previous post on the importance of the KPI process.