What is Gross Margin?
When a company sells a product or offers a service, it needs to price it higher than it costs to produce it. That amount is the gross income a company earns from its sales. But it’s often simpler and more prudent to look at gross margin: gross income represented as a percentage of net sales. Why? Because gross margin offers an important look at production efficiency that’s easy to compare and contrast over time or against specific criteria.
The higher the gross margin, the more money the company retains from the sale of its products. This offers critical insight for companies and investors alike into everything from the company’s free cash flow to its control over bottom-line costs. Companies with good gross margins are well-equipped to generate profits that fuel reinvestment and growth. Here’s a look at how a healthy growth margin helps.
Why is Gross Margin Important?
Because gross margin represents the amount of money the company makes from its sales, it also represents the amount of cash the company has to spend on growing the business. It’s an important factor in creating free cash flow, which enables the business to reinvest in itself. For example, the company may take money generated from a high-margin product and use it to market other products more effectively.
It’s also important to observe gross margin as a trend. The figure is unlikely to stay static over time. If the gross margin is falling, it could mean the company isn’t selling efficiently or that its operational expenses are increasing too quickly. Likewise, growth in margin can signal operational efficiency or a more efficient sales strategy. If a company is able to preserve or improve its margins, it’s a sign of maturing efficiency in production and/or sales.
How to Calculate Gross Margin
To calculate gross margin, companies need to collect data on net sales, as well as variable costs needed to produce its goods or services: the cost of goods sold (COGS). Most companies identify and report these figures quarterly or annually. The formula for calculating gross margin simply involves taking net sales less COGS:
Gross Margin = Net Sales – COGS
For example, ABC Company may sell Widgets for $20. If it costs the company $10 to produce them, the product’s margin is 50%. Gross margin is generally cited as a percentage in reference to the company’s sales. So, if ABC Company’s annual revenue is $1M and its COGS are $500,000, its gross margin is also 50%. Or, in other terms, ABC Company retains about 50 cents of each dollar it makes.
It’s important to note that if it’s a negative, the company is losing money on sales. And while this is alarming, there are some instances where it’s actually a strategic initiative called a loss leader. For example, there’s a prevailing adage that companies sell shaving razors at a loss (negative gross margin) to promote sales of razor blades, which have a much higher margin.
How to Increase Gross Margins
There are two ways to increase gross margins: sell more or spend less. This is also called targeting the top or bottom line. The top line represents total sales; the bottom line represents COGS and expenses. Companies can target one or both to improve COGS.
The Top-Line Approach
Companies can sell more to generate more revenue, which raises gross margin. There are also strategic selling opportunities that can increase margin. For example:
- Companies can push higher-margin products to increase gross margin
- More sales allow a company to exceed fixed costs and retain more revenue
- Raise prices on products to increase the value of sales and offset COGS
- Avoid selling at discounts or inadvertently reducing the value of goods
- Increase the average ticket or sale to drive higher product-level margins
The Bottom-Line Approach
The bottom-line approach to increasing gross margins focuses on cost savings. More specifically, it realizes the opportunity for higher margins through lower COGS.
- Reduce COGS by securing lower prices on labor or materials
- Reduce operational expenses that can lower gross margins
- Implement strategic purchasing to drive down COGS
- Improve vender relationships to curate more favorable terms
- Maximize the value of materials or labor to produce a higher-caliber product
Net Margin Comparison
Net margin is simply gross margin with ancillary expenses factored in. it’s a more complete look at the business’ profitability with all costs accounted for. Investors tend to pay more attention to it because it represents the company’s sales profitability more than its total operational profitability. It provides the answer to a more fundamental question: is the company selling well? This often has more bearing on an investment than the question of how efficiently management runs the company. It’s easier to replace management than fix a broken revenue model.
Is the Business Set Up for Success?
At its base, gross margin is an accurate representation of how profitable a company is in its sales. Because it represents the baseline amount the company retains after each sale, it’s a direct insight into that company’s ability to generate income. High gross margins mean the company is profiting significantly from its sales. Low margin means it needs to sell more to sustain profitable operations.
While net margin is a more accurate representation of total company profitability, gross margin ensures the company is making enough money on sales to sustain its core business model. And this data can tell an investor a lot about a business. To learn more about trending stocks with growth potential, sign up for the Profit Trends e-letter below.
The bottom line? If gross margin is poor, the company faces an uphill battle to grow and prosper. Good gross margin is the foundation of a healthy business model.