The Small Business Owner’s Guide (2022)

If you’ve watched the Winter Olympics, you know that scoring figure skating is complicated. If skaters want to know why they didn’t end up on the podium, their score totals alone won’t answer the question. Instead, they must see a percentage that measures how close their score is to the total number of points available. If the percentage is low, they need to focus not on adding more difficult moves, but on improving their execution. If the percentage is high, then their routine is not difficult enough to accrue a high number of points.

Just as they do for skaters, percentages can provide business owners with critical performance insights. And, as was the case for our theoretical skater, business owners can use percentage metrics to isolate problems and identify solutions.

In business accounting, one key metric expressed as a percentage is gross margin, which measures your potential for profit under current price conditions by showing you what percentage of revenue is used by cost of goods sold and what percentage is left over to cover your expenses. business operations and accrued as profit. If your business is not generating the desired profits, evaluating gross margins can help you identify the source of the issue and implement corrections.

What is gross margin?

Gross margin is a profitability metric, expressed as a percentage, that measures the portion of net sales revenue your company keeps after accounting for cost of goods sold. Also known as gross profit margin, this measure allows you to monitor profitability by comparing revenue generated to ongoing production costs.

How do you calculate gross margin?

The gross margin formula is expressed as:

(net sales – Cost of goods sold) / net sales = gross margin

In this case, cost of goods sold represents production costs (including material and labor costs) and net sales represent gross sales minus any returns received and discounts applied. Both net sales and cost of goods sold can be found on the profit and loss statement (or income statement), a financial statement that calculates a company’s net income over a specific reporting period.

Gross margin is different from gross profit, although both gross margin and gross profit are calculated over a period of time and are based on net sales and production costs. Unlike gross margin, gross profit is represented as a total dollar figure and is calculated using a formula net sales – cost of goods sold = gross profit.

For an example of how to calculate gross margin and gross profit, say a company sells Star Trek: The Next Generation–themed tableware generated $27,000 in revenue during the second quarter, with production costs totaling $10,000. This company’s gross profit is $17,000, because $27,000 (net sales) – $10,000 (cost of goods sold) = $17,000 (gross profit).

To calculate gross margin, the company will then divide gross profit by net sales, arriving at a percentage figure—in this case, 63%.

Gross margin vs. net margin

Unfortunately, business expenses don’t stop with the cost of goods sold. Gross margin isolates the profitability of a business’s core offering, but it does not take into account operating expenses (such as administrative and rental expenses), non-operating expenses or taxes. These numbers instead take into account the net profit margin, which is calculated by subtracting the cost of additional business expenses from revenue before dividing the remainder by net sales.

Net profit margin (or net margin) is expressed by the formula:

(net sales – cost of goods sold – operating expenses – tax liability) / net sales = net margin

Unless your business experiences a significant influx of non-operating revenue (say, you win a legal case and are awarded damages), your net profit margin will likely be lower than your gross margin. Monitoring this metric along with gross margin helps you isolate the percentage of revenue your company can save.

Gross margin advantage

Monitoring gross margin is key to improving the health of your business and increasing profitability. Because it is expressed as a percentage, your gross margin will not necessarily fluctuate as sales trends rise or fall in the same way as your gross profit and net income. Instead, it is a pure expression of the profit potential of your business model, which shows whether you have the opportunity to make money at your current selling price.

Gross margin can be used to inform pricing

One advantage of calculating gross margin is that it can help you determine whether you are pricing your company’s products or services appropriately. It can also help you react to changes in material costs, which directly affect your margins.

If, for example, you work in the construction industry, you may experience fluctuations in lumber and labor prices. If the price of materials doubles and your selling price stays the same, your gross margin will decrease.

For example, let’s say you normally charge $480.00 to build an 1,800 square foot home, knowing that your labor costs will total around $180,000 and material costs will run you $130,000. This will give you a gross profit of $160.00, because $480,000 – ($180,000 + $130,000) = $160,000. Your gross margin (or gross profit / net sales) is 33%, we $160,000 / $480,000 = .33.

Now let’s say your labor costs in the third quarter increased by 1.3 and material costs increased by 1.5. Your cost of goods sold is now $234,000 (labor) + $195,000 (materials), or $429,000, your gross profit is $51,000, and your gross margin is 10.6%. This is a significant drop in margins, and it’s a sign that your business needs to either find a way to reduce labor and material costs or increase its selling price.

Provides a good idea of ​​business profitability

As a measure of the viability of your business model, gross margin gives you a good idea of ​​the profitability (and future profitability) of your business.

For example, let’s go back to the construction company discussed in the example above. While both gross margin and gross profit show red flags in this example, gross margin is particularly helpful in evaluating profitability because it accounts for fluctuations in sales volume. Suppose the company builds six houses in Q3 and only one house in Q1 (before the increase in cost of goods sold). In this case, their gross profit in Q3 ($306,000) would exceed their gross profit in Q1 ($160,000).

Monitoring gross profit alone will lead these business owners to believe that their business is becoming more profitable over time. Examining the gross margin, however, reveals a significant decline in profit hidden in the reporting of gross profit with an increase in sales.

Shows growth potential

All kinds of factors can affect the short-term profitability of your business. Splurging on the best automatic milking machine might set your dairy back $20,000 in a month, and a hot July will usually see your ice cream sales skyrocket.

However, neither of these events are good indicators of your growth potential. To evaluate this, you need a metric that measures how much money you make from sales.

By telling you how profitable your business is before operating expenses are taken into account, gross margin can help you assess your growth potential. A high gross margin indicates that you are positioned for growth: all you need to do to increase profits is increase sales and minimize expenses. However, if your gross margins are poor, trying to increase profits by growing your business will yield little results. Instead, you can increase profits (and gross margins) by raising your selling prices, lowering your production costs, or both.

Final thoughts

Running a business is sometimes compared to building an airplane while flying it, and for good reason. Dealing with fluctuating material costs, staff turnover and market-driven fluctuations in demand (while relying on your business profits to pay your rent) can feel like revving an engine in the air while simultaneously pulling to avoid the Mountain Range.

Think of business accounting as your flight plan, and your accountant, if you have one, as your co-pilot. As you put out fires, metrics like gross margin can keep you on track to reach your goals—or tell you if you need to change course to protect profits.

source: https://www.shopify.co.id/blog/gross-margin