Over 4.5 million customers use QuickBooks.
Sign up for a free trial!
2021-06-30 13:42:12MoneyEnglishThis discussion defines gross margin, explains the components of the gross margin formula and presents strategies to increase gross margin...https://quickbooks.intuit.com/au/resources/au_qrc/uploads/2021/06/gross-margin-header.jpghttps://quickbooks.intuit.com/au/resources/money/how-to-calculate-gross-margin/What is gross margin and how to calculate it

What is gross margin and how to calculate it

10 min read

Why gross margin is key to measuring business performance

Successful managers use certain metrics to analyse results and make business improvements. Many executives use gross margin as a tool to increase profitability. If you focus on increasing gross margin, you can make dramatic improvements in your business.

This discussion defines gross margin, explains the components of the gross margin formula and presents strategies to increase gross margin and company profit.

How to calculate gross margin

The gross margin percentage is defined by this formula:

(Total revenue – cost of goods sold) / (total revenue)

To explain the formula, here is the 2020 income statement for Centrefield Sporting Goods:

How to calculate gross margin

Gross margin for Centrefield is:

($2,080,000 revenue – $1,680,000 cost of goods sold) / ($2,080,000 revenue) = 19.2%

For every dollar of sales revenue, Centrefield generates about 19 cents of gross margin. Note, however, that gross margin does not equal net profit. Keep in mind that some businesses use the term “cost of sales”, but this discussion will stick with the accounting term “cost of goods sold”.

Difference between gross margin and gross profit

A company’s gross margin is expressed as a percentage, and gross profit is stated as a dollar amount. Gross profit is defined as revenue less cost of goods sold.

For 2020, Centrefield has a 19.2% gross margin, and generates $400,000 in gross profit.

To calculate net income, Centrefield must subtract operating expenses. Here’s the formula to calculate net income:

($400,000 gross profit – $360,000 operating expenses) = $40,000 net income

To manage costs effectively and increase profits, you need to understand the components of cost of goods sold.

What expenses are included in the cost of goods sold?

The cost of goods sold balance includes both direct and indirect costs (overhead). Managers need to analyse costs and determine if they are direct or indirect. In addition, companies must label production costs as fixed or variable.

Direct vs indirect costs

Direct costs are directly related to producing a product or delivering a service. The most common direct costs are material and labour expenses. Indirect costs, on the other hand, cannot be traced to a specific product or service.

Centrefield Sporting Goods produces cricket gloves, and the cost of goods sold balance includes both direct and indirect costs.

Direct materials

Centrefield purchases leather material to manufacture cricket gloves, and each pair of gloves requires two square metres of leather. Both the cost of leather and the amount of raw materials required can be directly traced to each pair. As a result, Centrefield knows how much material is required to produce 1,000 pairs of gloves.

Direct labour

Cricket glove production also requires labour costs. Centrefield pays workers to operate cutting and sewing machines, and to stitch some portions of the gloves by hand.

Based on industry experience, the management knows how many hours of labour are required to produce a pair of gloves. The hours, multiplied by the hourly pay rate, equal the direct labour costs per pair. Centrefield also knows the direct labour costs required to produce 1,000 pairs of gloves.

The 2020 income statement reports that Centrefield incurred $680,000 in direct material costs and $1,000,000 in direct labour costs.

Indirect costs cannot be directly traced to a product or service. Instead, indirect costs are allocated to production. Most managers use the term “overhead” rather than “indirect costs”.

Allocation of overhead

Centrefield’s overhead costs are posted to operating expenses. The only way to recover overhead costs is to sell an item to a customer, so each dollar of overhead must be allocated to a product or service.

Overhead costs are allocated based on a level of activity. Here’s an example:

Tradespeople (carpenters, plumbers, tree service firms) incur mileage costs as they travel to each client’s location. The more kilometres driven, the more repair and maintenance costs incurred on vehicles.

A plumber may allocate overhead costs based on kilometres driven. If serving a customer requires 50 kilometres of driving, the plumber may add 10 cents per kilometre to cover vehicle repair and maintenance costs.

Overhead costs are frequently allocated using machine hours incurred, labour hours required, or simply using the number of units produced.

Fixed costs vs variable costs

Managers need to know why a particular cost is being incurred. One way to understand costs is to determine if the expense is fixed or variable.

  • Direct costs, such as materials and labour, are typically costs that vary with production. However, if a customer contract requires you to hire an outside firm to assess quality control, that one-off cost may be considered a fixed direct cost.
  • The cost paid to an office security company is a 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.

Inventoriable costs are not immediately assigned to the cost of goods sold account.

Inventoriable costs

Inventoriable costs are defined as all costs required to prepare an inventory item for sale. This balance includes the amount paid for the inventory item, and shipping costs. If a retailer must build shelving or incur other costs to display the inventory, the expenses are inventoriable costs.

The cost to train employees to use a product is also included in this category. When you buy a new piece of software, for example, you may incur costs to train your staff.

When the inventory item is sold, the inventoriable costs are reclassified to the cost of goods sold account. A retailer may have thousands (or even millions) of dollars in inventoriable costs that are not yet expensed.

Why analysing gross margin is important

Every manager should analyse the most important financial ratios needed to improve business results, and gross margin is often included in that analysis.

Revenue and cost of goods sold are two of the biggest balances in the income statement. If you can make changes to either balance, you can increase the bottom line. Operating expenses may be harder to reduce, since many of the costs are fixed.

How to improve gross margin

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

Increase revenue

Businesses can increase total sales by raising the selling price, but price increases can be difficult in industries that face a high level of competition. The ability to purchase products and services online also puts downward pressure on prices.

There are other strategies to increase net sales, but the most effective way is to increase 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 money on marketing to find new clients.

Increase repeat business

No problem is bigger than the cost to find customers. Consider this quote from the Harvard Business Review:

“Depending on which study you believe, and what industry you’re in, acquiring a new customer is anywhere from 5 to 25 times more expensive than retaining an existing one.”

Developing repeat business increases your monthly recurring revenue (MRR), which is the amount of revenue that 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.

According to Qualtrics: “CLV is a measurement of how valuable a customer is to your company with an unlimited time span as opposed to just the first purchase. This metric helps you understand a reasonable cost per acquisition.”

If you can shorten the sales cycle, you may be able to increase revenue.

Shorten the sales cycle

TrackMaven’s definition of the sales cycle: “It encompasses all activities associated with closing a sale. Many companies have different steps and activities in their sales cycle, depending on how they define it.”

One way to speed up the process is to leverage technology. In many instances, customers need more information before they can make a buying decision. If you can improve your website and provide clear answers to customer questions, people may buy sooner.

You’re spending money on marketing, and you can increase revenue by improving your marketing outcomes.

Improve marketing results

Give your customers a strong reason to stay with you by using these tactics:

Promotions: use data analytics to promote products and services that your customers want. If a sporting goods company knows that many customers buy cricket gloves and bats during the same shop visit, 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 behaviour, don’t forget about gathering testimonials. When a customer explains 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 emphasise that the survey won’t take much time to complete.

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

Another strategy to increase gross margin is to reduce costs.

Reduce material costs

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.

Some purchase managers add new suppliers to their vendor list, and ask the suppliers to compete on price. Before you add a new supplier, however, do your homework. The supplier must be able to ship quality products on time and at a reasonable price. Your decision about a supplier cannot be based solely on price.

The material costs you incur are driven by cost and usage. Analyse your production system and take steps to avoid wasting material. Every production process involves some level of unused material, or scrap. The goal is to minimise scrap, in order to reduce costs.

You may need to change the production system to reduce the amount of scrap you produce. Employee training can help workers minimise waste and work more efficiently.

Take a close look at your labour costs, and see if you can find ways to lower spending.

Decreasing labour costs

Just as with material costs, labour costs are a function of the hourly rate paid (price) and the number of hours worked (quantity).

The hourly rate you pay is closely tied to current economic conditions and the rate of unemployment. 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.

Invest in training so that employees can work efficiently. Well-trained workers can get more done in less time, and they make fewer mistakes.

So, where do you go from here?

What to do next

Use QuickBooks Online accounting software that can easily generate your firm’s gross margin, and other financial statement metrics. Compare your firm’s gross margin to other companies in your industry. Finally, put in the time to make improvements that lower costs and increase revenue.

Be proactive and make improvements sooner rather than later. Your business results will improve and your firm will increase in value.

This content is for informational purposes only and should not be considered legal, accounting or tax advice, or a substitute for obtaining such advice specific to your business. Additional information and exceptions may apply. Applicable laws may vary by state/territory or locality. No assurance is given that the information is comprehensive in its coverage or that it is suitable in dealing with a customer’s particular situation. Intuit Inc does not have any responsibility for updating or revising any information presented herein. Accordingly, the information provided should not be relied upon as a substitute for independent research. Intuit Inc does not warrant that the material contained herein will continue to be accurate nor that it is completely free of errors when published. Readers should verify statements before relying on them.

We provide third-party links as a convenience and for informational purposes only. Intuit does not endorse or approve these products and services, or the opinions of these corporations, organisations or individuals. Intuit accepts no responsibility for the accuracy, legality or content of these sites.

Rate This Article
Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

Help Your Business Thrive

Sign up for our newsletter

Thanks for signing up!

Check your inbox for a confirmation email.*

*Check your spam folder if you don’t see a confirmation email.

Related Articles

Gross profit formula: How to calculate gross profit for your business

Gross profit is your total sales, less the direct expenses required to…

Read more

Financial accounting glossary for business owners

Often, one of the trickiest parts of starting a new business is wrapping…

Read more

Lower costs and increase revenue using the gross profit formula

Gross profit is a great tool to manage both sales and cost…

Read more