Gross margin

Gross margin (also called gross profit margin or gross profit rate) is the difference between revenue and cost before accounting for certain other costs. Generally, it is calculated as the selling price of an item, less the cost of goods sold (production or acquisition costs, essentially).

Contents

Purpose

The purpose of margins is "to determine the value of incremental sales, and to guide pricing and promotion decision."[1]

"Margin on sales represents a key factor behind many of the most fundamental business considerations, including budgets and forecasts. All managers should, and generally do, know their approximate business margins. Managers differ widely, however, in the assumptions they use in calculating margins and in the ways they analyze and communicate these important figures."[1]

Percentage margins and unit margins

Gross margin can be expressed as a percentage or in total financial terms. If the latter, it can be reported on a per-unit basis or on a per-period basis for a company.

"Margin (on sales) is the difference between selling price and cost. This difference is typically expressed either as a percentage of selling price or on a per-unit basis. Managers need to know margins for almost all marketing decisions. Margins represent a key factor in pricing, return on marketing spending, earnings forecasts, and analyses of customer profitability." In a survey of nearly 200 senior marketing managers, 78 percent responded that they found the "margin %" metric very useful while 65 percent found "unit margin" very useful. "A fundamental variation in the way people talk about margins lies in the difference between percentage margins and unit margins on sales. The difference is easy to reconcile, and managers should be able to switch back and forth between the two."[1]

What is a unit?

"Every business has its own notion of a 'unit,' ranging from a ton of margarine, to 64 ounces of cola, to a bucket of plaster. Many industries work with multiple units and calculate margin accordingly. . . . Marketers must be prepared to shift between varying perspectives with little effort because decisions can be rounded in any of these perspectives."[1]

Construction

Investopedia defines Gross margin as:

Gross margin = (Revenue - Cost of goods sold) / Revenue[2]

It can be expressed in absolute terms:

Gross margin = net sales - cost of goods sold + annual sales return

or as the ratio of gross profit to cost of goods sold, usually in the form of a percentage:

\text{Gross Margin Percentage} = \frac{\text{Revenue - COGS}}{\text{Revenue}}*100%

Cost of sales (also known as cost of goods sold or COGS) includes variable costs and fixed costs directly linked to the sale, such as material costs, labor, supplier profit, shipping-in costs (cost of getting the product to the point of sale, as opposed to shipping-out costs which are not included in COGS), etc. It does not include indirect fixed costs like office expenses, rent, administrative costs, etc.

Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer it will be their markup over wholesale. Larger gross margins are generally considered ideal for most companies, with the exception of discount retailers who instead rely on operational efficiency and strategic financing to remain competitive with lower margins.

Two related metrics are unit margin and margin percent:

Unit margin ($) = Selling price per unit ($) - Cost per unit ($)
Margin (%) = Unit margin ($) / Selling price per unit ($)

"Percentage margins can also be calculated using total sales revenue and total costs. When working with either percentage or unit margins, marketers can perform a simple check by verifying that the individual parts sum to the total."[1]

To verify a unit margin ($): Selling price per unit = Unit margin + Cost per Unit
To verify a margin (%): Cost as % of sales = 100% - Margin %

"When considering multiple products with different revenues and costs, we can calculate overall margin (%) on either of two bases: Total revenue and total costs for all products, or the dollar-weighted average of the percentage margins of the different products."[1]

How gross margin is used in sales

Retailers can measure their profit by using two basic methods, markup and margin, both of which give a description of the gross profit. The markup expresses profit as a percentage of the retailer's cost for the product. The margin expresses profit as a percentage of the retailer's sales price for the product. These two methods give different percentages as results, but both percentages are valid descriptions of the retailer's profit. It is important to specify which method you are using when you refer to a retailer's profit as a percentage.

Some retailers use margins because you can easily calculate profits from a sales total. If your margin is 30%, then 30% of your sales total is profit. If your markup is 30%, the percentage of your daily sales that are profit will not be the same percentage.

Some retailers use markups because it is easier to calculate a sales price from a cost using markups. If your markup is 40%, then your sales price will be 40% above the item cost. If your margin is 40%, your sales price will not be equal to 40% over cost (indeed it will be approximately 67% above the item cost).

Markup

The equation for calculating the monetary value of gross margin is: gross margin = sales - cost of goods sold

A simple way to keep markup and gross margin factors straight is to remember that:

  1. Percent of markup is 100 times the price difference divided by the cost.
  2. Percent of gross margin is 100 times the price difference divided by the selling price.

Gross margin (as a percentage of Revenue)

Most people find it easier to work with gross margin because it directly tells you how much of the sales revenue, or price, is profit. In reference to the two examples above:

The $200 price that includes a 100% markup represents a 50% gross margin. Gross margin is just the percentage of the selling price that is profit. In this case 50% of the price is profit, or $100.

\frac{$200 - $100}{$200} * 100% = 50%

In the more complex example of selling price $339, a mark up of 66% represents approximately a 40% gross margin. This means that 40% of the $339 is profit. Again, gross margin is just the direct percentage of profit in the sale price.

In accounting, the gross margin refers to sales minus cost of goods sold. It is not necessarily profit as other expenses such as sales, administrative, and financial must be deducted.And it means companies are reducing their cost of production or passing their cost to customers. The higher the ratio, the better.

Converting between gross margin and markup (Gross Profit)

Converting markup to gross margin

\text{gross margin} = \frac{\text{markup}}{1 %2B \text{markup}}
Examples:
Markup = 100% = 1
\text{gross margin} = \frac{1}{1 %2B 1} = 0.5 = 50%
Markup = 66.7% = 0.667
\text{gross margin} = \frac{0.667}{1 %2B 0.667} = 0.4 = 40%

Converting gross margin to markup

\text{markup} = \frac{\text{gross margin}}{1 - \text{gross margin}}
Examples:
Gross margin = 50% = 0.5
\text{markup} = \frac{0.5}{1 - 0.5} = 1 = 100%
Gross margin = 40% = 0.4
\text{markup} = \frac{0.4}{1 - 0.4} = 0.667 = 66.7%

Using gross margin to calculate selling price

Given the cost of an item, one can compute the selling price required to achieve a specific gross margin. For example, if your product costs $100 and the required gross margin is 40%, then

Selling price = $100 / (1 - 40%) = $100 / 0.60 = $166.67

Differences between industries

In some industries, like clothing for example, profit margins are expected to be near the 40% mark, as the goods need to be bought from suppliers at a certain rate before they are resold. In other industries such as software product development, since the cost of duplication is negligible, the gross profit margin can be higher than 80% in many cases.

References

  1. ^ a b c d e f Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey: Pearson Education, Inc. ISBN 0137058292. The Marketing Accountability Standards Board (MASB) endorses the definitions, purposes, and constructs of classes of measures that appear in Marketing Metrics as part of its ongoing Common Language: Marketing Activities and Metrics Project.
  2. ^ Investopedia:Gross Margin Definition [1]