When you run a business a key performance metric to know is the gross margin – it is one of the most common questions asked in Dragons Den!
If you know this figure it will give you a good idea how much profit you are making, the performance of the business and how your business compares to others in the same industry.
What is the gross profit margin?
The gross profit margin is the percentage of profit you make before your general costs. The gross margin represents the percentage of revenue that the company retains after direct costs.
The higher the percentage the more of the revenue is kept by the business towards other costs or as profit.
So if a company had a gross margin of 40% this means that for each £1 of sales it keeps £0.40p towards administrative and general costs and profit.
How is it calculated?
Gross profit = Revenue – cost of goods sold
Gross margin = Gross profit/ revenue
Cost of goods sold include any cost which is directly attributed to generating the revenue. SO costs may be:
- Sales staff
- Purchase of stock
- Factory costs
What should my profit margin be?
There is no set figure – the general range varies from industry to industry. So typically supermarkets have very low gross margins but they sell in such large volumes that they make a fair bit of profit.
One way to find out what an ideal gross margin should be is to look at the accounts of your competitors in the same industry. However bear in mind that the may be changing their pricing or have a surge in costs for a reason that does not apply to your business.
So for example a competitor could reduce their selling prices (making them a loss leader) in an attempt to get a larger market share. You might think that their margins are really low compared to yours without realising it is part of their longer term pricing strategy.
Overall as a business owner you need to ensure that your business is making sufficient profit at a gross margin level in order to pay the bills and have some left over so you can take a salary or dividends.