Some financial consultants to retail and small businesses consider gross margin percentage (or gross margin, when expressed in dollars) to be the most important measure for analyzing costs and efficiency. Yet gross margin percentage is widely underutilized by small businesses, despite studies showing that those who track gross margin percentage consistently show higher profits.
Gross margin (or gross profit margin) is revenue in excess of the cost of goods sold. Gross margin percentage is simply gross margin expressed as a percentage and is calculated by dividing the gross margin by total sales. For example, if sales are $1,000 and the cost of goods is $400, gross margin is $600. The gross margin percentage is $600 / $1,000 (multiplied by 100 to get a percentage), or 60 percent.
The cost of goods includes the cost of materials plus production-related labor. It also can include allowances for breakage or similar expenses. It does not include office expenses or salaries, advertising or overhead expenses, such as rent and utilities. When pricing goods, a businessperson needs to have a gross margin percentage large enough to cover these other expenses plus a reasonable profit.
Many small retailers content themselves with using markup formulas to set prices. Markup and gross margin percentage are closely related. You can convert gross margin percentage to markup percentage by dividing gross margin by cost of goods and multiplying by 100. Typically, a retailer will use estimates of unit sales and of costs other than the cost of goods to determine markup and set prices for new products.
The value of tracking gross margin lies in the fact that it gives you “real-world” data to adjust prices obtained via theoretical methods of setting the markup. By taking figures for actual sales, gross margin percentage and expenses at the end of an accounting cycle (the end of the calendar quarter, for instance) and comparing these to the figures used to calculate markup, you can identify discrepancies and make adjustments to prices if need be.
Another benefit of tracking gross margin percentage is that it helps to identify inefficiencies so they can be corrected. Finally, experienced retailers often use gross margin to identify products that are suitable for feature items (using coupons and discounts) to build their volume and customer base. As useful as the gross margin measure is, remember that it is going to be most helpful when used along with other revenue information.