Understandably, you think about pricing products based on your competition. The theory is that a lower price will drive more customers to your doors. However, such an approach ignores the need to harness value, the need to cover business expenses, and the efficiency of your business. By knowing how to calculate gross margin, you can see the impact of your pricing decisions and where you can eliminate the waste that undermines your profitability. You need to pay attention to gross margin because potential investors will in examining your business.
Understanding Gross Margin
The gross margin is the percentage of sales revenues left after you account for the costs of producing the goods that you sell. With gross margin, you can see what you have left to pay fixed costs and profits for you and your investors.
Think of fixed expenses as overhead, or what the enterprise spends on overall operations, such as supplies, insurance, salaries and wages for office or support staff, rent and advertising, marketing and promotional expenses. These are not tied directly to production or acquisition of inventory.
Due to its function, gross margin may also go by the name “contribution margin”. That is, gross margin shows how much you have to contribute for overhead and profits from the sales of products.
What Types of Gross Margin Are There?
While gross margin generally is expressed as a percent, similar calculations can help assess the effectiveness of your pricing strategy and overall operations. You can calculate the gross margin as an absolute number in addition to as a percentage. This figure, called gross profit, is the difference between revenues and the costs of the goods sold. It represents the total available to pay overhead and distribute profits, if any, to the owners.
By dividing the absolute gross margin by the quantity of goods sold, you arrive at the gross margin per unit. This tells you how much each sale can contribute to overhead and profits.
How to Calculate Gross Margin
In calculating the gross margin, you find the gross profit as an absolute number and divide it by the revenues.
The formula for gross margin, expressed as a percentage, is:
Gross Margin = (Revenue-Cost of Goods Sold)/Revenue
Revenues consist of your total sales for the particular reporting period. For total sales, you multiply the units sold by the price.
To know how to calculate gross margin, you should be able to determine what items belong in cost of goods sold, otherwise known as variable costs. As the term suggests, these costs change with the quantity produced and result directly from the production. Variable costs fall generally into these categories:
- Raw materials or components;
- Labor and plant or production facility supervisors;
- Packaging, freight and shipping;
- Electricity and other utilities in the manufacturing facility;
- Depreciation on production equipment and machines;
When you know how to calculate gross margin, you can calculate the contribution margin ratio by simply using variable costs in place of cost of goods sold:
Contribution Margin Ratio = (Total Sales-Variable Costs)/Total Sales
You can also arrive at cost of goods sold by considering the movement of inventory, especially if you’re a retailer or wholesaler. The formula for this approach is:
Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory
For instance, suppose you began the month with your inventory of spinners at $400. Throughout the month, you buy $1,500 worth, and you have $700 worth remaining at the end. Your cost of goods sold for the month is $400 + $1,500 -$700, or $1,200.
Applications of Gross Margin
When you grasp how to calculate gross margin, you can both evaluate past performance and plan business strategy, especially if you’re given birth to the venture.
At an absolute minimum, your gross margin should be enough to cover the overhead. In other words, you have to find the break-even point as a starting place for pricing or determine the quantity to sell to meet it.
Say it costs you $3.00 to produce a spinner and your business runs overhead of $30,000. To break even, you need to achieve a gross profit of at least $30,000 to get out of the red. If you sell 10,000 spinners, then the cost of making those spinners is $30,000. To figure the revenues to at least cover overhead:
Gross Margin (Absolute) = Total Sales – Costs of Goods Sold (or)
$30,000 = Total Sales – $30,000
Total Sales = $60,000
Here, you need to set your price at $6.00 per spinner ($60,000/10,000 spinners). If you price the spinners at $10.00 each, you need to sell only 6,000 to achieve the total sales needed to break even.
In this example, your gross margin as a percentage amounts to 50 percent.
Aside from breaking even, you typically won’t find an overall benchmark gross margin. Instead, you need to compare your margin to competitors. A higher gross margin signals that you run a more efficient production operation or can sell at a higher price. As to the latter, a higher margin means you’re product is at least perceived as more valuable than competitors.
Also, consider the gross margin that is typical for your business. If you sell ice cream, expect your gross margins to run between 30 percent and 40 percent; frozen distribution contributes to much of your costs. Manufacturers and sellers of medical devices typically have margins north of 80 percent.
Practical Example of Knowing Gross Margin
Market Realist explains the factors that have lowered the gross margins of nitrogen segments among fertilizer companies in the first quarter of 2016. For example, the site reported that CF Industries saw margins decline from 44 percent in the first quarter of 2015 to 22 percent in the first quarter of 2016. This figure fell well south of the median gross margin of 38 percent among fertilizer firms. For PotaschCorp, margins went from 38 percent in March 2015 to 25 percent in March 2016.
For these and other nitrogen fertilizer companies, the drop in overall nitrogen prices lowered revenues from nitrogen fertilizer. With the lower revenues came generally lower margins. However, relatively low natural gas prices tempered some of the decline in gross margins. Nitrogen fertilizer makers rely on natural gas as the principal ingredient for the product.
Recommended read: How to Calculate Return on Investment?
Now that you have read how to calculate gross margin, you can begin to employ this critical concept in planning and evaluating your business. Please let us know how knowing gross margin has helped your bottom line and attracted investors to your business.