As all business owners know (or should know), the gross margin of a business is calculated as follows:
income less direct costs = gross profit (dollars)
gross profit / income = gross margin (percentage)
While the gross profit in dollars will fluctuate depending on the value of sales and costs in the period, the gross margin should stay reasonably consistent.
The gross profit must be sufficient to cover the overheads of the business, otherwise it will make a loss.
Consequently, the gross margin is a key number for you to know and maintain. Once the average gross margin is established, you should review it to see if it is sufficient for the business to achieve its strategic objectives.
In addition, you can use it to compare your business with similar business in the same industry (this is called benchmarking). If your current margin is 25% and the industry benchmark is 30%, then maybe you are selling your products and services too cheaply or your costs are too high.
As well as comparing your business to others, you should look at the trend of your gross margin across a period e.g. over several months. A downward trend could indicate that your costs are rising and you need to increase your prices.
You must share your aspirations for your gross margin with your sales and purchasing personnel so they can incorporate it into their sales pricing and purchasing decisions. If they are unaware of the company’s target gross margin they could be under-pricing sales or paying too much for purchases.
Why not put your gross margin in big red letters on the wall to keep everyone focused!
Author: Trevor Huett