Why (& how) small business owners should calculate their gross margins

Written by: Ken Boyd

January 31, 2023

Gross margin is the amount of money a small business holds after subtracting the direct cost of producing its goods and services from the revenue they earn. When it comes to increasing profitability, managers and accountants often look to gross margin since it shows the ratio of direct expenses to profits.

You can dramatically improve your business by increasing its gross margin. To help you, we’ll explain what gross margin is in detail, how to calculate gross margin, and share strategies to increase small business profits.

What is the gross margin percentage formula?

The gross margin percentage, or gross margin ratio, expresses the percent of revenue earned for every dollar spent. You can calculate your gross margin profit ratio with this formula:

Gross margin = (net sales – COGS) / (net sales)

For example, if your gross margin comes to 20%, you retain $0.20 and lose $0.80 to the cost of goods sold (COGS) every time you make a dollar.

Difference between gross margin and gross profit

Accountants usually write a company’s gross margin as a percentage. When they want to express gross margin in a dollar amount, they will call the result gross profit (GP). Keep in mind that some experts use the two terms interchangeably. You can learn how to find gross profit by using this formula:

Gross profit = Net sales – COGS

Note: Because gross profit is equal to net sales minus its cost of goods sold it will help illustrate your gross margin. By combining these metrics, you can better assess your business’s finances. GP analysis can also improve operations without weighing gross margins.

How to calculate gross margin

The basic steps needed to calculate gross margin include:

Calculating your net sales
Finding your cost of goods sold (COGS)

Once you have your net sales and COGS, you can just plug those two figures into the gross margin formula:

Gross margin = (net sales – COGS) / (net sales)

We’ll explore the nuances that go into these two calculations below.

1. Calculate your business’s net sales

To calculate gross margin, you need to calculate your net sales. Net sales equal your total revenue minus the money lost on returns, discounts, and allowances. This figure will appear in the direct cost portion of your income statement.

Note: Remember to use net sales instead of total revenue when calculating gross margin. Because total revenue doesn’t include losses on promotions and returns, this result is less accurate.

2. Find the cost of goods sold through your direct costs

The cost of goods sold includes expenses directly related to the production of goods. Indirect costs, such as marketing and admin salaries, don’t apply. To calculate gross margin, small business owners need to analyze costs and determine if they are direct or indirect.

Direct costs are directly related to producing a product or delivering a service. The most common direct costs are material and labor expenses.
Indirect costs, on the other hand, do not come from a specific product or service. Indirect costs include rent, utilities, insurance, and legal expenses.

We’ll explain the types of direct costs in COGS below:

Direct material costs

A business consumes direct materials to manufacture a product or provide a service. A product’s bill of materials lists the quantity and cost needed to make a product.

For example, a restaurant buys ground beef to make hamburgers, and each burger takes four ounces of beef. The restaurant directly traces the cost of ground beef and the other ingredients in each serving. As a result, the restaurant knows how many ounces of beef they need to order to meet demand.

Direct labor costs

Production requires labor costs. Companies pay workers to operate machines, handle materials, and assist with production by hand.

Based on industry experience, management knows how many hours of labor it takes to produce goods. The hours, multiplied by the hourly pay rate, equal the direct labor costs per product.

Direct inventoriable costs

Inventoriable costs refer to the amount paid to prepare an inventory item for sale. This balance includes the amount paid for materials, direct labor, freight-in, and manufacturing overhead. Here are a few examples of inventoriable fees:

If a retailer builds shelving or incurs other costs to display the inventory, the expenses are direct and inventoriable.
The cost of training employees to use a product counts as a direct cost. Like when you buy a new piece of software, you may incur costs to train your staff.
Shipping products to manufacturers or consumers incur a direct cost.

In the above cases, you can include inventoriable charges in your cost of goods sold. Other inventoriable costs, such as manufacturing overhead, count as indirect charges.

Special COGS considerations

As a general rule of thumb, fixed costs tend to be indirect, and variable costs are usually direct. However, there are some exceptions by cost or industry, so you should still review each charge before including it in the cost of goods sold.

Fixed costs vs. variable costs

Managers need to know why they incur a particular cost. One way to understand costs is to categorize the expense as fixed or variable.

Direct costs, such as materials and labor, are typical costs that vary with production. However, if a contract requires hiring an outside firm to assess quality control, you can consider that one-time cost a fixed direct cost.
The cost you pay to an office security company is an indirect, fixed overhead cost. You need the firm to protect company assets, regardless of how much you produce or sell.
The cost to repair machinery can vary based on how many hours you use the machines in a particular month. The repair cost is a variable overhead cost.

Industry costs

There is an essential difference between the cost of goods sold, depending on your firm’s industry:

Manufacturers produce a product and hold the completed product in inventory. These businesses incur direct material, direct labor, and overhead costs during production, contributing to the cost of goods sold.
Retailers and wholesalers or distributors purchase items for inventory. The price they pay for their inventory items makes up most of their cost of goods sold on the balance sheet. These firms do not manufacture a product. As a result, they don’t incur any direct material or labor costs that would add to their cost of goods sold.

Keep this distinction in mind when considering direct costs in the cost of goods sold.

Gross margin example

To put this all together, here is a gross margin example including a mock income statement.

From the income statement, we can learn that the company saw:

Net sales: $2,080,000
COGS: $1,680,000

Plugging these numbers into the gross margin formula, the equation is:

($2,080,000 net sales– $1,680,000 COGS) / ($2,080,000 net sales) = 19.2%

For every dollar of sales revenue, this firm generates about 19 cents of gross margin. However, that gross margin does not equal net profit. Unlike gross profit, net income accounts for indirect expenses. You can use gross margins to decide if direct costs detract from the bottom line more than indirect costs.

Tip: You can generate financial statements like this using bookkeeping software.

Evaluating gross margin results

Once you’ve plugged your net sales and COGS into the formula, you can review the result. Find an online resource like this NYU Stern School of Business roundup that notes the average gross margin for your industry. Once you’ve found the average gross margin in your field, you should attempt to meet or exceed the average.

Accounting data is most valuable when used to make financial improvements. You can apply several strategies to evaluate gross margin, including:

Focusing on net sales: Ultimately, cash flow keeps your business running. Make sure that returns, discounts, and allowances don’t cut too much into profits. Additionally, make sure your revenue exceeds direct and indirect costs.
Examining COGS: Managers need to review several direct costs. If your direct costs stay low, that points to high indirect costs or low revenue cutting into your bottom line.
Researching other KPIs: Gross margin isn’t the only test of profitability. Net margin includes indirect costs and managers should compare it to gross margin for a side-by-side comparison. Gross margin also feeds into net income, your bottom line.
Comparing past data: You will find the information you need to calculate gross margin on each annual income statement. Review your year-by-year margin to find trends in profits.
Looking at competitors: Gross margin averages vary by industry. Use your field and competitor’s average as a benchmark to gauge your success.

What is a good gross profit margin?

As you research gross margin averages, you’ll note the benchmarks differ greatly, depending on the industry. Your goal is to outperform competitors in your industry, not all companies. As a result, there isn’t an objective line separating high and low gross margins. A good gross margin is always relative to your field.

Here are a few gross margin benchmarks to get you started:

Advertising: 26.2%
Apparel: 53%
Auto: 14.3%
Computer services: 27.2%
E-commerce: 42.5%
Home furnishings: 27%
Healthcare products: 59%
Packaging and containers: 22%
Restaurants and Dining: 31.5%
Retail: 24.3%
Transportation: 21.3%

Improving your gross margin

As stated previously, gross margin is the percentage of each dollar of revenue after subtracting the cost of goods sold. So, to improve gross margin, focus on the components of the formula.

Increase revenue per transaction

In general, businesses increase net sales by:

Raising the selling price: Remember that price increases can be difficult in industries with a high level of competition. The ability to purchase products and services online also puts downward pressure on prices.
Increasing sales to your existing customer base: If you sell a quality product and provide a high level of service, customers may come back every month and year. You can increase sales and spend less on marketing to find new clients.

Increase repeat business

No problem is bigger than the cost of finding customers. According to the Harvard Business Review: “Acquiring a new customer is anywhere from five to 25 times more expensive than retaining an existing one.”

Developing repeat business increases your monthly recurring revenue (MRR)—the amount of revenue a company can reliably anticipate every 30 days. If customers keep coming back, they can generate revenue for years. Businesses measure the value of repeat business using customer lifetime value, or CLV.

Note: CLV measures a customer’s value to your company with an unlimited time span instead of only the first purchase. CLV gauges a reasonable cost per acquisition.

Improve marketing results

Improving your marketing outcomes can increase revenue. Give your customers a reason to stay with you by using these tactics:

Promotions: Use data analytics to promote products and services that your customers want. Suppose a sporting goods company knows that many customers buy baseball gloves and bats during the same store visit. In that case, they can promote the products together.
Rewards: Thank your customers by rewarding them. When a customer makes a certain number of purchases or reaches a specific dollar amount of activity, offer a discount on new business.
Testimonials: If you’re marketing to influence buyer behavior, remember to gather testimonials. When customers explain why they purchased your product, they may impact other people’s buying decisions.
Surveys: If you want to know what your customers want, ask them. Include surveys in each of your marketing channels and emphasize that the survey won’t take much time to complete.

Use your data analytics and survey results to make product improvements and add new product offerings.

Shorten the sales cycle

The sales cycle encompasses all activities associated with closing a sale. One way to speed up the process is to leverage technology.

For example, customers often need more information before making a buying decision. People may buy sooner if you improve your website and answer common questions clearly. Live chat, automated responses, and built-out FAQs come at a low price and can speed up the customer journey.

Reduce material costs

Another strategy to increase gross margin is to reduce costs on materials. You can reduce material costs by:

Negotiating a lower price with your suppliers: If you’re a large customer who buys materials every month, you may be able to negotiate a lower price based on your purchase volume.
Asking new suppliers to compete on price: Your purchasing managers can find new suppliers for their vendor list. However, before you add a new supplier, do your homework. The supplier must be able to ship quality products on time and at a reasonable price. You shouldn’t base your decision about a supplier solely on price.
Analyzing your production system and avoiding wasted material: The material costs you incur involve material prices and usage. Every production process involves some level of unused material or scrap. The goal is to minimize waste to reduce costs.
Changing the production system: A different approach can reduce the amount of scrap you produce. Employee training can help workers minimize waste and work more efficiently.

Decrease labor costs

Like material costs, labor costs are a function of the hourly rate paid (price) and the number of hours worked (quantity). The amount you pay ties into current economic conditions and the unemployment rate. If the economy is growing, you may need to pay a higher hourly rate to hire qualified workers. The opposite is true in a slowing economy.

You can decrease labor costs by:

Investing in traiing so employees can work efficiently. Well-trained workers can get more done in less time, and they make fewer mistakes.
Optimizing schedules and bringing in the most employees during a busy period. Conversely, schedule fewer workers during a lax period.
Reducing turnover to cut costs, because hiring a new employee costs more than retaining a trained one.
Incentivizing great performance with clear outcomes and specialized goals that play to employee’s strengths.

How gross margin analysis can be leveraged

Every manager should analyze the most important financial ratios needed to improve business results. More often than not, they include gross margin in that profitability analysis. When you start monitoring your gross margin balance, you can measure your performance against an industry benchmark to assess how you’re performing in your field.

Revenue and cost of goods sold are two of the biggest balances in the income statement. If you can change either balance, you can increase the bottom line. On the other hand, operating expenses may be harder to reduce when dealing with fixed costs. A review of key metrics will show the best route to improved profitability.

Advantages of gross margin analysis

Analyzing your gross margin can improve business operations in many ways:

Helps set pricing: You can use gross margin to set pricing at a competitive level without cutting into profits.
Highlights areas for improvement: If your company needs to cut costs or increase revenue, gross margin diagnoses financial issues.
Makes industry comparisons: Gross margin shows how profitable you are when compared to competitors.
Aids financial analysis: Gross margin is a key metric in any business. When paired with net margins and gross profits, it provides comprehensive financial information.

Limitations of gross margin analysis

While gross margins offer insight into finance, it comes with limitations:

Can’t depict overall profitability: Gross margins exclude the indirect costs of producing a good. Employee salaries, rent on a building, and marketing fees add to a product’s cost. By excluding these costs, gross margins aren’t 100% accurate.
Unfit for industry comparisons: Different industries come with their own structures and profit distributions. As a result, gross margin analysis won’t help you compare businesses in different industries.
Won’t account for outside factors: Gross margin analysis can only measure one company’s profitability. Outside factors, like increased production costs to secure a supplier or a decrease in the selling price to increase market share, won’t apply.

Use gross margins for growth

Your gross margin does more than paint a picture of company finances. In the right hands, it highlights the best path to improved profitability. Use accounting software to quickly generate your firm’s gross margin and other financial statement metrics. Once you’ve done that, you can:

Make improvements that lower costs and increase revenue
Gauge your firm’s growth potential
Make pricing decisions based on overall profitability
Point out areas for financial improvement

Be proactive and make improvements sooner rather than later. By learning the meaning of KPIs like gross margin, business results will improve and your firm will grow in value.

To get this actionable financial intelligence, try accounting software. It will generate your business’s gross margin and other financial metrics, compare your gross margin to other companies, and suggest improvements that lower costs and increase revenue.

This article originally appeared on the Quickbooks Resource Center and was syndicated by MediaFeed.org.