Is your commercial activity profitable? Find out by calculating your gross margin
Naturally, any business activity has to be profitable. That's why companies spend time monitoring a whole host of financial and commercial indicators to help them stay on course.
Gross margin is one of them. Very simple to master, it reveals the profitability generated by the sale of your products or services.
Are you applying the right pricing policy? Is it time to renegotiate prices with your suppliers? Calculating your gross margin gives you the answers to these key questions.
Today, we take a look at this indicator, how it differs from the net margin, the formula to apply... and many other aspects to consider to make your business successful.
What is gross margin?
Definition of gross margin
Gross margin, sometimes referred to as gross operating margin, is one of the key financial indicators used to manage your business.
It is not standardised, and its exact definition sometimes varies from one business sector to another. As a general rule, however, it refers to the difference between :
- the selling price of a product or service excluding tax,
- the cost price excluding tax.
This cost corresponds to the cost of :
- the purchase price of the goods excluding tax,
- associated with providing a service,
- relating to the deployment of the product or service.
In short, this calculation enables you to identify your gross profit margin, so that you can choose the best pricing policy.
Gross margin, net margin... What's the difference?
Be careful not to confuse these two indicators!
Expressed as a percentage, the net margin takes into account all the organisation's charges and taxes, with the aim of assessing its overall profitability.
It is therefore based on net profit, not on sales generated.
💡 Here's how the net margin is calculated:
| Net margin = Profit / Sales X 100 |
How is gross margin calculated?
Calculating gross margin
Gross margin is expressed in monetary units.
It is calculated as follows:
| Gross margin = Sales (excl. VAT) - Cost of goods sold (excl. VAT) |
☝️ Make sure you take into account :
- the purchase price of the goods,
- the change in stocks of goods,
- the purchase price of raw materials and supplies,
- the change in stocks of raw materials and supplies.
💡 Example:
You buy a product from your supplier at €10 excluding VAT. You sell it to your customer for €20 excluding VAT. Your gross margin is therefore €10.
| 20-10 = 10 |
Calculating gross margin
Sometimes it is more practical to calculate the gross margin as a percentage, particularly on the sales side.
This is known as the gross margin rate, and is calculated as follows:
💡 Example:
Let's go back to the example above. The gross margin reaches 50%.
| (10 / 20) X 100 = 50 |
How can I help?
Calculating your gross margin (or gross margin rate) may seem straightforward, but there are a number of factors to consider, especially if you are dealing with a large volume of goods.
So it's best to rely on reliable information, which you can find in your profit and loss account. This shows your sales and all your expenses for a given year.
We therefore recommend that you use accounting software such as Sage Business Compta, which centralises all this data in easy-to-access visual reports and dashboards.
What is the purpose of calculating gross margin?
Measure your profitability
Calculating your gross margin gives you a clearer idea of how profitable your business is.
The higher the result, the more profit you are making. If not, this indicator alerts you to the fragile balance of your pricing policy.
That's why this calculation is often made when launching a business, to determine the right selling prices for your products or services.
Make informed decisions
Nothing is set in stone in your business strategy, and more generally in your market. Stay on your toes to ensure your financial health.
Like all indicators, the gross margin enables you to assess the profits made at a given moment, so that you can make the right decisions later on, such as adjusting your pricing policy.
What's more, at the start of your business, this calculation helps you to determine the products and services on which you are going to concentrate your efforts as a priority (i.e. those that generate the best gross margin).
Calculate your selling prices
Sometimes it's a good idea to look at the problem in reverse.
In other words, start with your desired gross margin and then identify the ideal selling price for your products or services.
Negotiate better with your suppliers
Have you thought about questioning the prices charged by your suppliers?
Thanks to the gross margin calculation, you have a solid basis for positioning yourself and negotiating them down... and thus reducing your own selling prices in order to remain competitive.
Position yourself against the competition
Many companies compare their gross margins with those of their competitors.
If yours is higher, you can nibble away at market share by lowering your prices, without affecting your profitability.
How can you improve your gross margin?
There's no mystery to improving your gross margin. You have two options:
- Lower your production costs: as already mentioned, this involves renegotiating your prices with your suppliers.
We also advise you to look at your internal processes, particularly production processes. Automating certain tasks, for example, can considerably reduce your production costs! - Increase your sales prices: in this case, always proceed judiciously... so that your customers don't run away! Go about it sparingly, gradually and across your entire catalogue.
Furthermore, justify this increase by the added value of your products and services, and by your expertise.
Other key indicators to be aware of
There are a number of other financial indicators you need to be aware of to improve your sales performance. Monitor them in conjunction with your gross margin!
💡 Here are a few examples:
- calculating the sales margin: very similar to the concept of gross margin (the two are in fact regularly confused!), the sales margin focuses on the costs of purchasing goods, and does not include, for example, production costs.
| Sales margin = Sales price excluding VAT - Purchase price excluding VAT |
- calculating the margin rate : as with the gross margin rate, the result is expressed as a percentage:
| Sales margin = (Sales margin / Purchase price excluding VAT) x 100 |
- calculating the production margin: as its name suggests, this indicator is of interest to you if you produce the products you sell yourself, in order to measure the profitability of the operation.
| Production margin = Production for the year - Production cost of goods sold |
What should I bear in mind?
The gross margin is part of the large family of financial indicators. By calculating the difference between the selling price of a product or service excluding VAT and its cost price excluding VAT, you can accurately assess your profitability, opt for the best pricing policy and align yourself with your competitors.
But while this is a simple operation, it does require a great deal of rigour. That's why it's a good idea to use the data centralised in your accounting software.
And of course, depending on the nature of your business, you will gain in relevance by studying your gross margin in the light of other indicators, such as net margin, sales margin or production margin.
Article translated from French