Gross Margin Explained: Understanding the Benefits and Calculation

As a small business owner or freelancer, you may be struggling to effectively analyze your profitability metrics. However, these metrics are critical for securing long-term business growth and making informed business decisions. The key metric that gives insight into the profitability of your business is gross margin. Business owners need to consistently look for ways to improve productivity and profitability, calling on the need to understand what gross margin is, how to calculate it, and the different benefits it provides.

What is Gross Margin?

Gross margin, commonly referred to as gross profit margin, compares the cost of goods (COGS) sold to sales. This gives a key insight, based on direct costs, into how profitable your goods and services are. Gross margin is commonly expressed as a percentage of sales, but can also be used in a currency format. All businesses should utilize a gross margin calculation to analyze the cost of conducting business, compared to the sales generated. Moreover, the gross margin percentage should be shown on the Income Statement, according to Generally Accepted Accounting Principles, making it an important metric to understand.

Understanding the Items Included in Gross Margin

To calculate gross margin, you take your revenue minus the cost of goods sold. The cost of goods sold includes any direct expense associated with selling your product or service. Common expenses include direct labor, supplies and freight. The industry you are operating in will determine which expenses fall into these categories.

For example, a business in the construction sector would see a high expense level for supplies in cost of goods sold, whereas an online freelance business would commonly report software expenses. The expense needs to be directly tied to the revenue stream to be considered a cost of goods sold. Revenue is any income you receive from your primary business purpose. Miscellaneous income is specifically excluded from the calculation. Determining the qualifying income and expenses is the first step to accurately calculating gross margin.

Calculating Gross Margin

When it comes to calculating gross margin, there are a few different steps to keep in mind. The first step is to determine the relevant income and cost of goods sold. Once you have these numbers, you subtract the cost of goods sold from revenue. This will give you your gross margin in currency form. If you decide you want to calculate gross margin as a percentage, you will take the number previously calculated and divide it by the revenue.

Understanding how to calculate gross margin can be difficult, so let’s try a problem:

Jake runs a freelance business and is trying to determine how profitable he is, including other income and expenses. He determines his revenue is $10,000. Jake currently reports $2,000 in software expenses and $1,000 in other expenses, directly tied to his freelance business. What is the gross margin as a percent and in currency form?

Following this gross margin formula:

You would take ($10,000 – ($2,000 + $1,000)) to get a gross margin in currency form of $7,000. Dividing this number by the original revenue figure of $10,000 gives a gross margin percentage of 70%.

What Does Gross Margin Tell Me?

The gross margin tells you how efficient your sales are at generating revenue. The higher the gross margin, the more profit your business is generating. Keep in mind that gross margin does not include operating, selling and general expenses, meaning it will not show the bottom-line profitability of your business. Instead, gross margin focuses on the return of direct costs. To be beneficial, the gross margin, both in currency form and percentage, should yield a positive number.

A negative result indicates your business is losing money, based on the costs associated with generating a profit. Moreover, the gross margin for which your business should strive differs according to your industry. For example, recent industry statistics show the average gross profit for a building materials business is 28.32%,whereas that of a software business averages at 73.59%. These are two starkly different ranges, making it important to weigh your gross profit percentage with others operating in the same industry.

Weighing the Advantages and Disadvantages

Both the advantages and disadvantages of gross margin calculations should be considered. Business owners and freelancers are given added transparency into the direct costs, when using the gross margin calculation. Fully understanding if you are generating a profit based on the direct costs is critical to not only plan for growth, but to also realize where changes are needed.

Additionally, the ability to compare data between different time-frames is critical. If your gross margin is consistently 30% and you notice that it comes out to 25% for the current period, this tells you that your direct costs are increasing at a higher rate, compared with the  revenue.

In these cases, you would need to adjust the price you charge customers, in order to remain at the same profitability level. However, if you are trying to grow your business, your prices should increase by more than the adjustment needed to generate additional profit. Despite a mounting list of benefits, there are some drawbacks to take into consideration. Gross margin does not include all the expenses associated with your business because it only focuses on direct costs.

Bank charges, office expenses, professional fees, travel, and office wages are common expenses not included in the cost of goods sold. These expenses can add up, making it important to analyze the net profit in addition to the gross profit. Furthermore, for a business with no direct costs, the gross margin in currency form will be the same number as the revenue, providing no additional value. Finally, industries in a specific niche will have trouble comparing their gross margin to other similar businesses.

Ways to Improve Gross Margin

If you are generating an unfavorable gross margin figure, there are steps you can take to improve it. The first method is to increase your selling price, without increasing direct costs. Consider raising your prices by 3%-5% to improve your gross margin and put more money into your pocket at the end of the year, although you don’t want to shock customers and lose sales because your prices have dramatically increased.

Another viable solution for improving your gross margin is to lower direct costs. Reach out to different vendors for quotes on the supplies you frequently purchase. Additionally, don’t be afraid to ask for bulk order discounts and special financing incentives.

You are more likely to lower your direct costs by placing fewer, but larger orders. Finally, look for different ways to maximize your business productivity and business processes. This will be more attainable for businesses that frequently purchase supplies and use machinery. Nevertheless, if your freelance business is based online, search around for software programs that can add value and efficiency to your products and services.

The Difference Between Contribution Margin and Gross Margin

Many small business owners and freelancers confuse gross margin and contribution margin, making it important to understand the key differences. Contribution margin analysis profitability, based on a single product or service through variable costs, whereas gross margin looks at the profitability of the entire business through direct costs .

The cost of goods sold only includes direct costs, most of which are fixed. Certain expenses, such as advertising, can be directly tied to each product. However, these expenses usually aren’t included in the cost of goods sold. As a result, the contribution margin looks at each variable product cost that can be linked to the sale, giving you an insight on the profitability per product and service sold.

The contribution margin and gross margin are two different metrics that analyze profitability, both of which are important to calculate on a regular basis. Understanding the impact of direct and variable costs on profitability leads to greater business success and growth.

What Tools are Available to Help?

Continuously pooling the data to calculate gross margin can be an overwhelming task, which is why there are calculators and software programs available to ease the burden. One such calculator is the Omni Calculator, which produces a gross margin based on factors you input.

In addition, you can easily change your inputs to plan for business growth and implement effective changes in your pricing and direct costs. Another tool that many small businesses see success with is a software program that keeps track of key data, such as contracts and time spent working on projects. Many online businesses don’t have direct costs, but instead utilize their personal time to generate revenue. In these cases, Fiverr Workspace can give your online business information on the hours associated with each online contract, providing value when calculating the gross and contribution margins.

Summary

Effectively utilizing the gross margin calculation relies on having a full understanding of its basics and the calculation method. Your business should not overlook the benefits and insights gross margin provides, making it important to calculate on a regular basis. Start implementing gross margin into your regular metric calculations to make viable changes to your profitability and productivity today.