Gross Margin: What It Is and How to Calculate It
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Summary:
Gross margin is a key indicator of a business’s ability to generate profit. To calculate gross margin, subtract the direct costs of producing or acquiring goods or services from the total revenue.
As a business owner, understanding your financial metrics is critical to making informed decisions and driving profitability. One such metric that’s essential for measuring business profitability is the gross margin.
But what does gross margin mean, and what does it tell you about your business? Keep reading to learn more about the gross margin metric, how to calculate it, and how businesses can use it to measure profitability.
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What is gross margin?
Gross margin is a financial metric that measures the percentage of revenue that remains after deducting the cost of goods sold (COGS). In other words, it tells you how much profit you’re making on each sale after taking into account the cost of producing or acquiring the product.
For example, let’s say your business sells a product for $100, and it costs you $60 to produce or acquire that product. Your gross margin would be $40, which is the difference between the selling price and the cost of goods sold.
Gross margin is an important metric because it gives you an idea of how much money you’re making on each sale, which indicates how profitable your business is. A high gross margin means that you’re making a lot of money on each sale, while a low gross margin means that you’re making less money on each sale. By understanding this value, you can make informed decisions about pricing, costs, and profitability.
Pro Tip
It’s worth noting that gross margin is different from gross profit. Gross profit is the difference between revenue and COGS, while gross margin is expressed as a percentage of revenue. For example, if your business has $1,000 in revenue and $600 in COGS, your gross profit would be $400. Your gross margin, however, would be 40%, which is the gross profit ($400) divided by the revenue ($1,000).
How to calculate gross margin
Calculating gross margin is relatively straightforward. The formula for gross margin is:
To use this formula, you’ll need to know your revenue and your cost of goods sold. Revenue is the total amount of money you’ve earned from sales, while COGS is the total cost of producing or acquiring the products you sold.
Here’s a step-by-step guide to calculating gross margin:
- Determine your revenue. Add up the total amount of money you’ve earned from sales over a specific period, such as a month, quarter, or year.
- Determine your COGS. Add up all the costs associated with producing or acquiring the products you sold during the same period. This might include raw materials, labor costs, manufacturing overheads, and shipping costs.
- Subtract COGS from revenue. Subtract your total COGS from your total revenue to get your gross profit.
- Calculate gross margin. Divide your gross profit by your revenue and multiply the result by 100 to get your gross margin as a percentage.
For example, let’s say your business had $200,000 in revenue and $110,000 in COGS over the past quarter. Your gross profit would be $90,000 ($200,000 – $110,000), and your gross margin would be 45% ([$90,000 / $200,000] x 100).
Gross margin examples
To help illustrate how to calculate gross margin, let’s look at two examples:
Example 1: E-commerce store
An e-commerce store sells t-shirts for $20 each. The store’s COGS for each t-shirt is $12, which includes the cost of the blank t-shirt, printing, and shipping. In the last month, the store sold 1,000 t-shirts and generated $20,000 in revenue.
Revenue: $20,000
COGS: $12 x 1,000 = $12,000
Gross Profit: $20,000 – $12,000 = $8,000
Gross Margin: $8,000 / $20,000 x 100 = 40%
COGS: $12 x 1,000 = $12,000
Gross Profit: $20,000 – $12,000 = $8,000
Gross Margin: $8,000 / $20,000 x 100 = 40%
Example 2: Coffee shop
A coffee shop sells coffee for $3 per cup. The shop’s COGS for each cup is $1, which includes the cost of coffee beans, milk, and cups. In the last month, the shop sold 2,000 cups of coffee and generated $6,000 in revenue.
Revenue: $6,000
COGS: $1 x 2,000 = $2,000
Gross Profit: $6,000 – $2,000 = $4,000
Gross Margin: $4,000 / $6,000 x 100 = 66.67%
COGS: $1 x 2,000 = $2,000
Gross Profit: $6,000 – $2,000 = $4,000
Gross Margin: $4,000 / $6,000 x 100 = 66.67%
These examples show how gross margins can vary depending on the business and the industry. The e-commerce store has a lower gross margin because it has higher COGS, while the coffee shop has a higher gross margin because it has lower COGS.
What is a 25% gross margin?
A 25% gross margin means that for every dollar in revenue generated, 25 cents are left over after accounting for the direct costs of producing or acquiring goods or services. In other words, 25% of revenue is available to cover overhead expenses and generate profit.
Using gross margin to measure business profitability
Gross margin is a key metric for measuring business profitability. A high value means that a business is generating more revenue relative to its costs and is therefore more profitable. Conversely, a low value means that a business is spending more money on production costs relative to the revenue it generates, which can reduce profitability.
Using gross margin as a benchmark, businesses can determine whether they’re generating enough profit to cover their operating expenses and investments. In addition, comparing a gross margin to industry averages and competitors can help businesses understand how they stack up in their respective markets.
Here are some ways that businesses can use gross margin to measure profitability:
- Monitor over time. By tracking gross margin over time, businesses can identify trends and changes in their profitability. A declining value could indicate a rise in production costs or pricing pressures. On the other hand, an increasing value could suggest that a business is more efficient or finding new ways to increase revenue.
- Compare to industry benchmarks. Comparing gross margin to industry averages and competitors can help businesses understand how they’re performing relative to their peers. If a business has a lower value than the industry average, it may need to evaluate its costs and pricing strategies to remain competitive.
- Analyze by product or service. Business owners can also analyze their gross margins by product or service to identify which products are the most profitable. By understanding which products or services have higher gross margins, businesses can decide where to allocate resources and which products to focus on.
By understanding gross margin and its role in measuring profitability, businesses can make informed decisions about pricing, costs, and investments to improve their financial performance.
Key Takeaways
- Gross margin is a financial metric that measures a business’s profitability using that company’s COGS and total revenue.
- While a high value indicates higher profitability, a low gross margin represents lower profitability.
- You can use gross margin to monitor profitability over time, compare to industry benchmarks, and analyze by product or service.
- Businesses can use this value to make informed decisions about pricing, costs, and investments to improve their financial performance.
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