The Importance Of Gross Margin

Dear M & M:

Can you explain gross margin and the importance it would have on my business?

– Susan

Dear Susan:

Gross margin is the amount of total sales a company has left over after they have paid their costs to produce goods and services sold. The more left over or the higher the percentage, the more your business keeps on each dollar of sales to pay for other costs associated with the business. Many times people do not pay attention the importance of your businesses’ gross margin. The amount of money you have left over after paying for what you are selling has a direct link to manage an effective profitable business.

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). Gross margin is a measure of the effectiveness and production efficiencies in getting ones product or services ready for sale.

Remember, “cost of sales (also known as cost of goods sold or COGS) includes variable costs and fixed costs directly linked to the sale, such as material costs, labor, supplier profit, shipping-in costs (cost of getting the product to the point of sale, as opposed to shipping-out costs which are not included in COGS), etc. It does not include indirect fixed costs like office expenses, rent, administrative costs, etc.” – Wikipedia.

Knowing the gross margin on all the products or services one sells will enable you to better price what the market will bear in your selling area.  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 important. Now you can find out what are all the other costs like hiring a sales force, accounting or opening a store front to sell out of.

A grocery store has a 20% gross margin, a jeweler has a 50% gross margin and an automotive repair business has a 40% gross margin.  Using industry averages is a great tool for comparisons, but one needs to figure your own costs and revenue to determine your own numbers. How can you sell anything without knowing exactly what it is costing you to have available for sale?

Keep in mind gross margins change over time. Remember that gross margins change over time through increased or reduced costs and through increased or decreased inefficiencies throughout the company. Not paying attention to or ignoring gross margins is like ignoring the health of one’s business.  A company’s gross margin is a clear measurement of what your costs are just getting your product or service ready for sale.

One has to know what that cost is (Gross Margin) before you set out to determine pricing and how much will be left over to pay for all the other things you need to do to in order to sell it.



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