Gross margin

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Markup vs. Gross Margin (by Adrian Chiogna) Markup vs. Gross Margin (by Adrian Chiogna)..jpg
Markup vs. Gross Margin (by Adrián Chiogna)

Gross margin is the difference between revenue and cost of goods sold (COGS), divided by revenue. Gross margin is expressed as a percentage. Generally, it is calculated as the selling price of an item, less the cost of goods sold (e. g. production or acquisition costs, not including indirect fixed costs like office expenses, rent, or administrative costs), then divided by the same selling price. "Gross margin" is often used interchangeably with "gross profit", however the terms are different: "gross profit" is technically an absolute monetary amount and "gross margin" is technically a percentage or ratio.

Contents

Gross margin is a kind of profit margin, specifically a form of profit divided by net revenue, e. g., gross (profit) margin, operating (profit) margin, net (profit) margin, et cetera.

Purpose

The purpose of margins is "to determine the value of incremental sales, and to guide pricing and promotion decision." [1]

"Margin on sales represents a key factor behind many of the most fundamental business considerations, including budgets and forecasts. All managers should, and generally do, know their approximate business margins. Managers differ widely, however, in the assumptions they use in calculating margins and in the ways they analyze and communicate these important figures." [1]

Percentage margins and unit margins

Gross margin can be expressed as a percentage or in total financial terms. If the latter, it can be reported on a per-unit basis or on a per-period basis for a business.

"Margin (on sales) is the difference between selling price and cost. This difference is typically expressed either as a percentage of selling price or on a per-unit basis. Managers need to know margins for almost all marketing decisions. Margins represent a key factor in pricing, return on marketing spending, earnings forecasts, and analyses of customer profitability." In a survey of nearly 200 senior marketing managers, 78 percent responded that they found the "margin %" metric very useful while 65 percent found "unit margin" very useful. "A fundamental variation in the way people talk about margins lies in the difference between percentage margins and unit margins on sales. The difference is easy to reconcile, and managers should be able to switch back and forth between the two." [1]

Definition of "Unit"

"Every business has its own notion of a 'unit,' ranging from a ton of margarine, to 64 ounces of cola, to a bucket of plaster. Many industries work with multiple units and calculate margin accordingly Marketers must be prepared to shift between varying perspectives with little effort because decisions can be rounded in any of these perspectives." [1]

Investopedia defines "gross margin" as:

Gross margin (%) = (Revenue – Cost of goods sold) / Revenue [2]

In contrast, "gross profit" is defined as:

Gross profit = Net sales – Cost of goods sold + Annual sales return

or as the ratio of gross profit to revenue, usually as a percentage:

Cost of sales, also denominated "cost of goods sold" (COGS), includes variable costs and fixed costs directly related to the sale, e. g. material costs, labor, supplier profit, shipping-in costs (cost of transporting the product to the point of sale, as opposed to shipping-out costs which are not included in COGS), et cetera. It excludes indirect fixed costs, e. g. office expenses, rent, and administrative costs.

Higher gross margins for a manufacturer indicate greater efficiency in turning raw materials into income. For a retailer it would be the difference between its markup and the wholesale price. Larger gross margins are generally considered ideal for most businesses, with the exception of discount retailers who instead rely on operational efficiency and strategic financing to remain competitive with businesses that have lower margins.

Two related metrics are unit margin and margin percent:

Unit margin ($) = Selling price per unit ($) – Cost per unit ($)
Margin (%) = Unit margin ($) / Selling price per unit ($) * 100

"Percentage margins can also be calculated using total sales revenue and total costs. When working with either percentage or unit margins, marketers can perform a simple check by verifying that the individual parts sum to the total." [1]

To verify a unit margin ($): Selling price per unit = Unit margin + Cost per Unit
To verify a margin (%): Cost as % of sales = 100% – Margin %

"When considering multiple products with different revenues and costs, we can calculate overall margin (%) on either of two bases: Total revenue and total costs for all products, or the dollar-weighted average of the percentage margins of the different products." [1]

Use in sales

Retailers can measure their profit by using two basic methods, namely markup and margin, both of which describe gross profit. Markup expresses profit as a percentage of the cost of the product to the retailer. Margin expresses profit as a percentage of the selling price of the product that the retailer determines. These methods produce different percentages, yet both percentages are valid descriptions of the profit. It is important to specify which method is used when referring to a retailer's profit as a percentage.

Some retailers use margins because profits are easily calculated from the total of sales. If margin is 30%, then 30% of the total of sales is the profit. If markup is 30%, the percentage of daily sales that are profit will not be the same percentage.

Some retailers use markups because it is easier to calculate a sales price from a cost. If markup is 40%, then sales price will be 40% more than the cost of the item. If margin is 40%, then sales price will not be equal to 40% over cost; in fact, it will be approximately 67% more than the cost of the item.

Markup

The equation for calculating the monetary value of gross margin is: Gross margin = Sales – Cost of goods sold

A simple way to keep markup and gross margin factors straight is to remember that:

  1. Percent of markup is 100 times the price difference divided by the cost.
  2. Percent of gross margin is 100 times the price difference divided by the selling price.

Gross margin (as a percentage of revenue)

Most people find it easier to work with gross margin because it directly tells you how much of the sales revenue, or price, is profit:

If an item costs $100 to produce and is sold for a price of $200, the price includes a 100% markup which represents a 50% gross margin. Gross margin is just the percentage of the selling price that is profit. In this case, 50% of the price is profit, or $100.

In a more complex example, if an item costs $204 to produce and is sold for a price of $340, the price includes a 67% markup ($136) which represents a 40% gross margin. This means that 40% of the $340 is profit. Again, gross margin is just the direct percentage of profit in the sale price.

In accounting, the gross margin refers to sales minus cost of goods sold. It is not necessarily profit as other expenses such as sales, administrative, and financial costs must be deducted. And it means companies are reducing their cost of production or passing their cost to customers.[ clarification needed ] The higher the ratio, all other things being equal, the better for the retailer.

Converting between gross margin and markup (gross profit)

Converting markup to gross margin

Examples:
Markup = 100% = 1
Markup = 66.7% = 0.667

Converting gross margin to markup

Examples:
Gross margin = 50% = 0.5
Gross margin = 40% = 0.4

Using gross margin to calculate selling price

Given the cost of an item, one can compute the selling price required to achieve a specific gross margin. For example, if your product costs $100 and the required gross margin is 40%, then

Selling price = $100 / (1 – 40%) = $100 / 0.6 = $166.67

Gross margin tools to measure retail performance

Some of the tools that are useful in retail analysis are GMROII, GMROS and GMROL.

GMROII: Gross Margin Return On Inventory Investment

GMROS: Gross Margin Return On Space

GMROL: Gross Margin Return On Labor

Differences between industries

In some industries, like clothing for example, profit margins are expected to be near the 40% mark, as the goods need to be bought from suppliers at a certain rate before they are resold. In other industries such as software product development the gross profit margin can be higher than 80% in many cases. [3]

In the agriculture industry, particularly the European Union, Standard Gross Margin is used to assess farm profitability.

Related Research Articles

Cost accounting

Cost accounting is defined as "a systematic set of procedures for recording and reporting measurements of the cost of manufacturing goods and performing services in the aggregate and in detail. It includes methods for recognizing, classifying, allocating, aggregating and reporting such costs and comparing them with standard costs." (IMA) Often considered a subset of managerial accounting, its end goal is to advise the management on how to optimize business practices and processes based on cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

In economics, profit maximization is the short run or long run process by which a firm may determine the price, input, and output levels that lead to the highest profit. Neoclassical economics, currently the mainstream approach to microeconomics, usually models the firm as maximizing profit.

Cost-plus pricing is a pricing strategy in which the selling price is determined by adding a specific markup to a product's unit cost. An alternative pricing method is value-based pricing.

Markup is the difference between the selling price of a good or service and cost. It is often expressed as a percentage over the cost. A markup is added into the total cost incurred by the producer of a good or service in order to cover the costs of doing business and create a profit. The total cost reflects the total amount of both fixed and variable expenses to produce and distribute a product. Markup can be expressed as a fixed amount or as a percentage of the total cost or selling price. Retail markup is commonly calculated as the difference between wholesale price and retail price, as a percentage of wholesale. Other methods are also used.

Cost of goods sold

Cost of goods sold (COGS) is the carrying value of goods sold during a particular period.

Break-even (economics)

The break-even point (BEP) in economics, business—and specifically cost accounting—is the point at which total cost and total revenue are equal, i.e. "even". There is no net loss or gain, and one has "broken even", though opportunity costs have been paid and capital has received the risk-adjusted, expected return. In short, all costs that must be paid are paid, and there is neither profit or loss.

In marketing, customer lifetime value, lifetime customer value (LCV), or life-time value (LTV) is a prediction of the net profit attributed to the entire future relationship with a customer. The prediction model can have varying levels of sophistication and accuracy, ranging from a crude heuristic to the use of complex predictive analytics techniques.

Net income Measure of the profitability of a business venture

In business and accounting, net income is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period.

Profit margin, net margin, net profit margin or net profit ratio is a measure of profitability. It is calculated by finding the net profit as a percentage of the revenue.

Marginal revenue

In microeconomics, marginal revenue (MR) is the additional total revenue that will be generated by increasing product sales by one unit.

In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income to net sales, usually presented in percent.

Operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is.

Contribution margin

Contribution margin (CM), or dollar contribution per unit, is the selling price per unit minus the variable cost per unit. "Contribution" represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs. This concept is one of the key building blocks of break-even analysis.

Pricing strategies

A business can use a variety of pricing strategies when selling a product or service. The price can be set to maximize profitability for each unit sold or from the market overall. It can be used to defend an existing market from new entrants, to increase market share within a market or to enter a new market.

Gross Margin Return on Inventory Investment (GMROII) is a ratio in microeconomics that describes a seller's return on every unit of currency spent on inventory. It is one way to determine how profitable the seller's inventory is, and describes the relationship between the profit earned from total sales, and the amount invested in the inventory sold. Generally for a seller, the higher the GMROII the better. Since the inventory is a very widely ranging factor in a seller's investment in working capital, it is important for the seller to know how much he might expect to gain from it. The GMROII answers the question "for each unit of average inventory held at cost, how many units of currency of gross profit I generated in one year?" GMROII is traditionally calculated by using one year's gross profit against the average of 12 or 13 units of inventory at cost. GMROII may vary depending on which segment we are analyzing, but a rule of thumb is that a GMROII of typical retailer is above 3.0.

Inventory turnover Measure of the number of times inventory is sold or used in a time period

In accounting, the Inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year. It is calculated to see if a business has an excessive inventory in comparison to its sales level. The equation for inventory turnover equals the cost of goods sold divided by the average inventory. Inventory turnover is also known as inventory turns, merchandise turnover, stockturn, stock turns, turns, and stock turnover.

Contribution margin-based pricing is a pricing strategy which works without any mention of gross margin percentages. (German:Deckungsbeitrag) It maximizes the profit derived from a company's assortment, based on the difference between a product's price and variable costs, and on one's assumptions regarding the relationship between the product's price and the number of units that can be sold at that price. The product's contribution to total operating income is maximized when a price is chosen that maximizes the 'contribution margin per unit X number of units sold'.

Cost–volume–profit analysis form of cost accounting

Cost–volume–profit (CVP), in managerial economics, is a form of cost accounting. It is a simplified model, useful for elementary instruction and for short-run decisions.

Financial ratio

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

Monopoly price

A monopoly price is set by a seller with market power; that is, a seller who can drive up the price by reducing the quantity he sells, as opposed to "perfect competition", under which sellers simply take the market price as given. The simplest case of market power is a monopoly, a firm that lacks any viable competition and is the sole producer of the industry's product. Because a monopoly has market power, it can set a monopoly price that is above the firm's marginal (economic) cost. Since marginal cost is the increment in total required to produce an additional unit of the product, the firm is thus able to earn positive economic profits if its fixed cost is low enough.

References

As of February 5, 2012, this article is derived in whole or in part from Marketing Metrics: The Definitive Guide to Measuring Marketing Performance by Farris, Bendle, Pfeifer and Reibstein . The copyright holder has licensed the content in a manner that permits reuse under CC BY-SA 3.0 and GFDL. All relevant terms must be followed.

  1. 1 2 3 4 5 6 Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey: Pearson Education, Inc. ISBN   0-13-705829-2. The Marketing Accountability Standards Board (MASB) endorses the definitions, purposes, and constructs of classes of measures that appear in Marketing Metrics as part of its ongoing Common Language in Marketing Project.
  2. Definition of 'Gross Margin'. investopedia.com
  3. http://smallbusiness.chron.com/net-profit-percentage-goals-business-23447.html - "Software companies had a 90 percent gross profit margin, as of 2011, according to FinanceScholar."