Gross margin: understand what it is and learn how to calculate it!

Within a company's financial organization, several metrics are essential to its operation and to indicate its financial health. These metrics are essential for everything, including the final cost of products.

And among them is the gross marginThis indicator shows the value compared to the cost of production, making it fundamental for operation and for organizing prices and other factors.

Therefore, in this article, we'll cover all the details about this indicator and how you can calculate it within your company. Read on to learn more.

What is gross margin?

Gross margin is an essential financial metric for a company that expresses the difference between revenue from a company's sales and the costs directly associated with production or cost of goods sold, thus revealing the value generated by each transaction.

In simple terms, it's a percentage that shows the profit a company makes on each sale. It's a crucial indicator of an organization's profitability, offering a comprehensive perspective on its operational efficiency.

Gross margin: what is it for?

This margin plays a fundamental role in assessing a company's profitability, acting as an initial indicator that precedes the analysis of other more detailed financial information, such as operating costs and general and administrative expenses.

At its core, this metric reveals the amount available to cover fixed costs and, equally important, to generate profit.

By providing a primary view of the relationship between sales revenue and the direct costs associated with production, gross margin highlights efficiency in generating profit before considering additional charges.

Therefore, it presents itself as a crucial indicator for managers, allowing them to understand the company's ability to cover its fixed costs and, at the same time, generate profits.

By prioritizing gross margin in financial analysis, decision-makers can formulate more informed strategies, identifying areas for improvement in operational efficiency and thus boosting the organization's overall profitability.

Thus, gross margin serves as a valuable starting point for assessing a company's financial health and growth potential.

How to calculate gross margin?

Gross margin is a financial metric that measures a company's profitability before considering other financial information, such as operating costs and general and administrative expenses. In other words, this metric indicates the amount available to cover fixed costs and generate profit.

To calculate it, you need to consider Sales Revenue, or gross profit, and subtract it from the Cost of Goods Sold.

See a practical example:

Consider a company that sells clothing. The company had sales revenue of R$100,000 last month. The cost of goods sold was R$60,000.

See the formula:

Gross Margin = (Sales Revenue – Cost of Goods Sold) / Sales Revenue

Gross margin = (100,000 – 60,000) / 100,000

Gross margin = 40%

Therefore, the company's gross margin is 40%. This means that the company is earning R$ 40 for every R$ 100 sold.

As we've shown, there are two formulas. Let's take a look at the same calculation with the other formula to understand how it works:

Gross Margin = (Gross Profit / Sales Revenue) * 100

Gross profit = Sales revenue – Cost of goods sold

Gross profit = 100,000 – 60,000

Gross profit = 40,000

Gross margin = (40,000 / 100,000) * 100

Gross margin = 40%

The result is the same, i.e. 40%.

What other types of margin are there?

In addition to gross margin, there are two other types of margins that are important for companies: operating margin and net margin.

• Operating margin: Operating margin is a financial metric that measures a company's profitability before considering taxes and dividends.
• Net margin: Net margin is a financial metric that measures a company's profitability after considering all costs, including taxes and dividends.

What is the difference between gross margin and net margin?

The difference between gross margin and net margin is that gross margin measures a company's profitability before considering operating costs, general and administrative expenses, taxes, and dividends, while net margin measures a company's profitability after considering all these costs.

Therefore, gross margin is a simpler measure of a company's profitability, as it only considers direct production or purchasing costs.

Net margin, on the other hand, is a more comprehensive measure of a company's profitability, as it considers all costs, including indirect ones.

How to evaluate gross margin in a business?

To assess the gross margin in a business, it is necessary to consider the following factors:

• Sector: Gross margin varies from industry to industry. For example, technology companies typically have higher gross margins than service companies.
• Competition: Gross margin also varies depending on competition. If competition is high, companies need higher gross margins to be competitive.
• Cost structure: Gross margin is also affected by a company's cost structure. Companies with lower direct production or purchasing costs generally have higher gross margins.

As an example, to provide a baseline, we've separated the average gross margins of different sectors so you can see how your company is doing. Remember, your account doesn't need to be exactly the same; this is a general average across sectors:

Why is it important to evaluate a company's gross margin?

Gross margin is an important metric for assessing a company's profitability. It measures the amount of revenue a company receives after subtracting direct production or purchasing costs.

Assessing gross margin is important for several reasons:

• Comparison with the competition: Gross margin can be used to compare a company's profitability with that of its competitors. This can help a company identify its strengths and weaknesses relative to its competitors.
• Monitoring over time: Gross margin can be used to track a company's profitability over time. This can help the company identify trends and identify areas for improvement.
• Decision making: Gross margin can be used to make strategic decisions, such as increasing production, expanding the market, or reducing costs.

Thus, in general, assessing gross margin is an important tool to help companies improve their profitability and make strategic decisions.

How to improve gross margin?

There are several ways to improve a company's gross margin. Some key strategies include:

• Reduce direct production or purchasing costs: This is the most direct strategy for improving gross margin. Companies can reduce their direct costs in several ways, such as negotiating better prices with suppliers, improving production or purchasing efficiency, and reducing waste.
• Increase selling prices: Raising selling prices is another way to improve gross margin. However, it's important to be careful not to raise prices too much, as this can lead to customer loss.
• Improve the mix of products or services: A company's product or service mix refers to the combination of products or services it offers. Companies can improve gross margin by focusing on products or services with higher gross margins.
• Increase productivity: Companies can improve gross margin by increasing productivity—that is, producing more products or services with the same resources. This can be achieved through investments in technology, employee training, or improvements in production or purchasing processes.

The best strategy for improving a company's gross margin depends on specific factors, such as the company's industry, its competitors, and its cost structure.

To do this, you must carefully analyze your specific circumstances to identify the strategies that are best suited to them.

Here are some more tips that may be useful when improving your company's gross margin:

• Compare your company's gross margin to that of your competitors to identify areas for improvement.
• Track gross margin over time.
• Take inventory of your costs.
• Set gross margin goals and create a plan to achieve them.

By following these tips, companies can improve their gross margin and increase their profitability.

Did you like the tips? See more on the website to keep your company profitable.