An important financial ratio that any budding entrepreneur needs to include as part of his business planning is the desired gross margin percentage. The gross margin percentage is a reliable barometer for gauging profitability. If the gross margin percentage is decreasing, it is a sign the business owner needs to take corrective measures to maintain acceptable profit levels.
A business' gross profit margin is the measure of the revenue it generates in relation to the costs associated with the sales of its products or services, commonly referred to as cost of goods sold. Typical costs include materials used to manufacture a product, as well as labor expenses. Gross margin is important because it indicates to the business owner how profitable of an enterprise he is operating, and whether he needs to make adjustments to his business plan.
A business' gross margin is typically expressed as a percentage of sales. To calculate, subtract cost of goods sold from revenue, and divide the result by the revenue figure. For example, a company that generates $500,000 in sales and incurs $300,000 in costs of goods sold operates with a gross margin of 40 percent. This is obtained by subtracting $300,000 from $500,000 to get $200,000, which is then divided by $500,000. A decrease in gross margin percentage is an indication that the business is becoming less profitable. In this example, a decrease of even one percentage point would mean the business's profits have decreased by $5,000, from $200,000 to $195,000.
One way to correct a decreasing gross margin percentage is to look for ways to generate more revenue. One possible remedy is to evaluate the company's pricing structure to determine if a price increase would be an appropriate measure. An important factor to consider is whether an increase would keep the pricing structure in line with that of competitors. If the business produces goods that are higher in quality than those of the competition, customers may also be more willing to tolerate a higher price.
Another way to combat a decreasing gross margin percentage is to explore ways to reduce fixed costs. In some cases, taking a close look at operating procedures can uncover waste that can be easily eliminated, such as by purchasing cheaper materials that do not have a negative impact on quality. If bloated labor costs appear to be the problem, it may involve reducing working hours, or making the painful decision to eliminate jobs.