Why gross margin is key to measuring business performance
Successful managers use certain metrics to analyze 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 2019 income statement for Centerfield Sporting Goods:
Gross margin for Centerfield is:
($2,080,000 revenue – $1,680,000 cost of goods sold) / ($2,080,000 revenue) = 19.2%
For every dollar of sales revenue, Centerfield 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 2019, Centerfield has a 19.2% gross margin, and generates $400,000 in gross profit.
To calculate net income, Centerfield 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 analyze costs and determine if they are direct or indirect. In addition, companies must label production costs as fixed or variable.
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, and these costs are added 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 and may not incur any direct material or direct labor costs that would be an added component of their cost of goods sold.
Keep this distinction in mind as you review the components of the cost of goods sold, starting with the difference between direct costs and indirect costs.
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 labor expenses. Indirect costs, on the other hand, cannot be traced to a specific product or service.
Centerfield Sporting Goods produces baseball gloves, and the cost of goods sold balance includes both direct and indirect costs.
Centerfield purchases leather material for manufacturing baseball gloves, and each glove requires two square yards of leather. Both the cost of leather and the amount of raw materials required can be directly traced to each glove. As a result, Centerfield knows how much material is required to produce 1,000 gloves.
Baseball glove production also requires labor costs. Centerfield 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 labor are required to produce a glove. The hours, multiplied by the hourly pay rate, equal the direct labor costs per glove. Centerfield also knows the direct labor costs required to produce 1,000 gloves.
The 2019 income statement reports that Centerfield incurred $680,000 in direct material costs and $1,000,000 in direct labor 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
Centerfield’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 miles driven, the more repair and maintenance costs incurred on vehicles.
A plumber may allocate overhead costs based on miles driven. If serving a customer requires 30 miles, the plumber may add 10 cents per mile to cover vehicle repair and maintenance costs.
Overhead costs are frequently allocated using machine hours incurred, labor 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 labor, are typical costs that vary with production. However, if a customer contract requires you to hire an outside firm to assess quality control, that one-time 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 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 analyzing gross margin is important
Every manager should analyze 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.
When you start monitoring your gross margin balance, you need a tool to measure your performance against an industry standard. Compare your results to a benchmark to assess how you’re performing in your particular industry.
How to evaluate gross margin results
Start the process by finding a resource that lists the average gross margin for your industry. This source reports that Miscellaneous Retail (#59 in the list) has an average gross margin of 31.8%, and a retailer that fits this category should attempt to meet or exceed the average.
As you scroll through any list of gross margin averages, you’ll note that the benchmarks differ greatly, depending on the industry. Your goal is to outperform competitors in your industry, not all companies.
Accounting data is most valuable when it is used to make financial improvements. There are a number of strategies you can apply to improve gross margin, and you should consider using each approach.
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.
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 defines 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 baseball gloves and bats during the same store 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 behavior, 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 emphasize 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 by usage. Analyze 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 minimize 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 minimize waste and work more efficiently.
Take a close look at your labor costs, and see if you can find ways to lower spending.
Decreasing labor costs
Just as with material costs, labor 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 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.
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