Understanding Gross Margin

Gross margin measures how much money a company makes by selling products, excluding direct expenses such as labor costs (indirect costs such as management costs or debt are not included)。For example, the profit of designer clothing (the price is high, but the production cost may not be so high) may be higher; the profit of paper clips (the price is lower) may be lower。Companies can use gross margins to determine whether a product is worth selling and what their production budget is.。

What is income？

Clear terminology is key to understanding gross margins - the first term is "revenue"。Revenue is all funds generated by the company, including all cash received from the sale of products or services after applying any discounts or deductions。

Other sources of revenue not related to the sale of products or services are not included in revenue。For example, if a company owns real estate or other investments and those investments bring money, that income is not included。Sales revenue includes only revenue directly from the sale of goods and services。

For example, if a car company takes every 7.selling 10,000 cars for $50,000, then the company's revenue is 7.500 million dollars。The cost of making these cars, advertising them, or paying sales staff does not change revenue - this is a measure of the money entering the business。

How to Calculate Cost of Sales (COGS)？

The next term is "cost," specifically, "cost of goods sold" (aka COGS)。You can calculate the cost of goods sold by adding up all the direct costs of a product and then multiplying by the number of units of that product purchased by the customer。

The calculation includes the materials involved in producing the products and the direct labor costs of making them.。If the cost of batteries, metal, leather, and rubber required to assemble a car is $50,000, and the salary cost of the employees who actually assemble the car is $50,000, then the cost of sales of a car will be 5.$50,000。

Raw material cost + production labor cost = cost of goods sold

Opening inventory value + inventory purchase + labor cost directly involved in production - ending inventory value = current cost of sales

Indirect costs associated with the sale of goods, such as salaries paid to salespeople or research and development costs, are not part of the cost of goods sold。

How to Calculate Gross Margin？

To calculate the gross margin, subtract the cost of sales of all the company's products from the company's sales revenue and divide the result by the company's sales revenue。

For example, a company selling value 7.$500 million of widgets with a cost of sales of 5.$500 million, the company's gross margin would be 7.$500 million - 5.$500 million = $200 million, $200 million / 7.$500 million = 26.67%

This means that the company can convert 26% of each widget sales..67% for other commercial purposes, the remaining 73.33% to cover the cost of production of widgets。

What is net profit？

There are multiple "links" in the profit chain, and gross margin is just the beginning。Gross margin is not the only type of profit that companies and investors calculate。investors and firms use net profit, contribution margin and standard margin for different。

Net profit margin measures how much revenue a company has left after paying all expenses, including the cost of goods sold and indirect costs such as taxes, executive salaries, etc.。

To calculate net profit, subtract all the company's expenses from the company's total revenue and divide the result by the company's revenue, a ratio that can be used to measure the company's overall profitability。

What is Marginal Contribution?？

The marginal contribution measures the revenue of the product minus all the variable costs of the product.。

Variable costs are costs that vary with the number of products produced。Unlike fixed costs, fixed costs remain constant regardless of how much product the company produces。

A typical example of variable costs is the raw materials needed to produce an item, such as the leather of sports shoes。One fixed cost is machinery used to produce shoes, such as leather cutting equipment。Whether you build one or 100 widgets, the cost of the machine is the same。

To calculate the marginal contribution, subtract the variable cost of the product from the sales revenue it brings in and divide the result by the sales revenue。

What is the standard profit margin?？

The standard profit margin is a measure of the amount of gross margin remaining after deducting the company's estimated fixed costs, including utilities, rent or property taxes, payroll, insurance, and maintenance.。

Suppose a company spends $50,000 a month producing a product that sells for $7.$50,000。The company's gross margin is 2.$50,000, or 33.34%。If the company's fixed costs reach $20,000, the standard profit is only $50,000, or $50,000 / 7..$50,000 = 6.67%。

Standard profit uses estimated fixed costs, which is how it differs from net profit using actual costs。Standard profit margin does not take into account unforeseen expenses。

Why Gross Margin Is Important？

Gross margin measures how much money is left after a product is produced and sold, which can be reinvested in the company to help it cover other costs, can be used to expand, repay debt, or can be returned to shareholders。

Gross margin can also be used to measure production costs versus revenue。If gross margins decline, the company may raise prices or consider cost savings in the production process。If the gross margin increases, it means that the company may have more funds available for other purposes。For example, if the price of cotton rises, the gross margin of your favorite clothing chain will fall, which may prompt them to raise prices or use cheaper and lower-quality materials。

Investors care about gross margin because it shows whether a company can make a profit by selling products, and also shows the efficiency of its production processes and how much pricing power it has.。

Higher gross margins may be a positive state, but gross margins don't give you a full picture of the underlying situation。