A financial report will contain a range of metrics, numbers and ratios. For keeping the organization financially healthy, the management must be capable of understanding these reports. Of the several concepts in these reports, one of the most important is the gross margin. Knowing how to calculate margin is essential as well.
What is the Gross Margin?
For an organization, the gross margin is the total sales revenue less the cost of the goods sold, divided by the total sales revenue. It is commonly expressed in the form of a percentage. This metric represents the total sales revenue that is retained by the company after paying for the direct costs linked with the production of goods or provision of services sold.
In bookkeeping, all major metrics are dealt in percentages rather than monetary figures. Percentages are better when it comes to making analytical decisions. They are better for making comparisons on performances and trends, leading to more accurate analysis.
A higher gross margin means that the organization retains more on each sale they make. The money can then be used for meeting the debt obligations and other costs.
How Do You Calculate Gross Margin?
Calculating gross margin is easy. The difficulty arises when there are multiple goods offered by the organization. Different products and services tend to have their own price structures. Be that as it may, the total sales figure should include the sales of all the products and/or services offered by the organization. The total costs involved in producing them must be calculated as well.
Deducting the above two will provide the gross profit of the organization. The gross profit is given in monetary units and shows the amount of money that the organization actually made on the products and services after paying all the costs involved in production and sales.
Now, the gross profit can be deducted from the sales made. This will provide a percentage which is the gross margin.
The Importance of Gross Margin
The gross margin per unit is an invaluable metric for organizations. There are several reasons as to why this is the case. Here are a few scenarios in which the gross margin is used.
The Bottom Line: The gross margin can affect the bottom line and net profit. A higher gross margin shows that the organization is capable of having a robust net income as well as a better operating profit margin. It makes it easier for new businesses to achieve the break-even point and start generating profit.
The Operating Expenses: Organizations that calculate gross margin can determine how much they can spend on the operating costs and still have profit left over. Increasing the gross margin allows the organization to overcome operating costs and generate profit. This makes it necessary for the gross margin to be calculated.
The Cash Flow: The cash flow of the organization can be affected by the gross margin. A significant amount of money is generally spent on inventory costs for the acquisition or production of goods. The gross margin can help in determining the ideal markup percentage for the sale of the inventory so as to generate a bigger cash inflow. It becomes easier to make extra investments for the expansion of the business when the margin shows that sales and inventory can be quickly converted into profit.
The Product Pricing: Gross margin calculation can help in assisting the management for the determination of product prices. The management can use the gross margin and the costs of production to finalize the sales price required for generating the desired profit.
The Profitability: Organizations need to keep a track of their profitability trends so as to ensure their continued success. The gross profit can fluctuate, being affected by changes in revenue, fixed costs and variable costs, making it unsuitable for tracking profitability trends. Organizations should calculate the gross margin instead as it is a better indicator of the same.
The Future Plans: An organization’s management must plan ahead for the future. Gross margin takes into account the production costs and the revenue. As a result, using it for the forecast of future revenues and costs can help in determining the overall profitability. The gross margin can be used by the organization for the development of various future scenarios before implementing the necessary changes.
Knowing how to calculate gross margin is certainly important for an organization. However, it is also important for the management to understand how this percentage can be used in bettering the organization’s business.