What is gross margin? Know its importance for your business

8 września 2022

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What is gross margin? Know your ...

One of the most important functions of your company's accounting department is to calculate the various profit margins. As such, it is necessary not only for them to know the figures, but to be able to understand them. Therefore, here we will discuss what gross margin is, one of the most important values for measuring the profitability of a business.

That said, let's look at what gross margin is, its meaning, technical definition, how to calculate it, its usefulness and the difference between gross margin and net margin.

What is gross margin?

Gross margin is understood as the resulting difference between the capital input and the total sales. Generally, it is stated as a percentage and represents the profit in relation to the expenses of the products or services you offer.

For the same reason, the gross margin does not take into account the operating or maintenance costs of the business, such as the payment of salaries, taxes or real estate services. However, if the gross margin percentage is high, it means that the profits of the business are in good shape.

Thus, the concept of gross margin is nothing more than the measurement (in percentage) of the profits that a company capitalizes after deducting expenses by means of a simple formula. The greater the gap between these, the more dividends the business actually accumulates.

Indeed, the gross margin in accounting is quite a useful tool for calculating both the value of a business and its productivity in certain fiscal cycles.

Technical definition of gross margin

Technically speaking, gross margin is the calculation of the profit obtained by a company after trading a product or service. In other words, we are talking about the differential between the commercial selling price (excluding taxes) and production costs. In fact, it is also known as profit margin and ultimately tells us about a company's gross revenue.

Gross margin: formula

Knowing what gross margin is is probably one of the most reliable mechanisms for measuring the financial health of your company. But how to calculate it? Let's look at its accounting formula:

Gross margin is the result of the operation that divides gross profit (the total profit of a company after deduction of costs) by gross revenue (the total money accumulated through commercial activity) and then multiplying it by 100 to obtain the gross margin percentage.

(Gross Profit / Gross Revenues) x 100 = Gross Margin

Let's look at an example.

Example of the gross margin formula

Let's assume that your company grosses one million dollars (USD 1,000,000) during a fiscal year. Let's also assume that the gross profit in that period amounts to half a million dollars (USD 500,000).

Then: (500,000 / 1,000,000) x 100 = 50.

In this case, your gross profit margin will be 50%.

Gross margin profit

Of course, it is not enough to know what gross margin is; we also need to master its useful features. Here are the four most important ones:

It measures the effectiveness of the company or its financial health.
It allows you to calculate the gross profit margin, i.e., the price of the products or services your business trades after deducting your investment or production costs.
It enables the comparison of effective sales with other competing companies.
It facilitates the commercial projection to decide future management strategies, without affecting the break-even point of trade or the minimum operating figure that every business must set to continue operating and that includes workers' salaries, payment of services, minimum investments, etc.

Gross margin vs. net margin

By knowing what the gross margin is and calculating it, we can also deduce the net margin. This is inaccessible if the gross margin is not deducted. In addition, it results from the ratio of net revenue to total revenue.

Like the expected gross margin, it is usually expressed in percentage terms and its calculation is the result of dividing the net profit (that obtained by the company after all expenses) by all the capital accumulated through sales of goods or services. At the end, as in the gross margin formula, the result is multiplied by one hundred to obtain the net margin percentage.

FAQs on what is gross margin

In terms of frequently asked questions that relate to what is gross margin, we find the following:

What is meant by gross margin?

In short, let's remember that the formula for calculating this value is the product of dividing gross profit by gross revenue. This figure is then multiplied by one hundred to obtain a percentage.

How to calculate the gross margin?

In summary, let's remember that the formula for calculating this value is the product of dividing gross profit by gross revenue. Then multiply that figure by one hundred to obtain a percentage.

What should a company's gross margin be?

It is generally accepted that if a company's gross margin exceeds 20%, it is positive.

At the end of the day, gross margin gives you a record that you can use to see if your management, marketing and merchandising efforts are paying off.

Remember that, fortunately, almost any difficulty in the business world is reversible with the necessary corrective measures. So start taking this financial resource into account so you can ensure that your management activity is on the right track.

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