Unless they’re particularly interested in the details of business finances, a lot of people tend to switch off when they start hearing terms like ‘gross profit’ or ‘net revenue’.
But as a business owner, there are a handful of figures that are essential to know about your business so you can make good strategic decisions, and your gross margin is one of them.
In simple terms, this is the measure that tells you how your production costs relate to the money you make.
Knowing your gross margin will help you to see how the costs that go into your product balance with the revenue you get from it, and identify any areas for improvement.
It’s just one of several factors that, if measured and tracked in the right way, can be really valuable tools for informing your decisions and achieving your business goals.
What is gross margin?
Gross margin is the difference between your net revenue and cost of goods sold (COGS), represented as a percentage.
It’s slightly different to gross profit, which is generally shown as a monetary amount instead.
It’s also different to net margin, which takes all of your business’s expenses into account. With gross margin, you’re looking specifically at production costs.
You can work it out using the following calculation:
(Revenue – COGS) / Revenue
So, for instance, if you have a net revenue of £10,000 and your products cost £6,000 in total to make, you would find the difference between those figures (£4,000) then divide that by £10,000 to reach 0.4 – in other words, a gross margin of 40%.
Another way of putting it is that for every £1 you sell, you make 40p in gross profit.
Improving your gross margin
There are two main ways to increase your gross margin – raising your revenue, or lowering the cost of production.
Raising your revenue often means raising prices, or limiting the number of discounts you offer. It could also be about working on increasing your sales. This, in turn, can help you to lower your production costs per unit as working with large quantities tends to be more efficient.
To lower your COGS, you could look at improvements to the production process, or consider automating or outsourcing. Looking for competitively-priced suppliers or negotiating with your current ones is another option – again, being able to buy in bulk often helps to lower costs.
Another approach is to opt for cheaper raw materials. This comes with the risk of lowering your product’s quality, however, which you might end up paying for in the long term.
Alternatively, think about your overall strategy and business model. If you’re pouring a lot of time and resources into products that take a long time to sell, would it be better to narrow your focus and replace them with the products you know are profitable?
It’s a good idea to diversify your products to some extent, but in many cases it can be useful to identify your niche and focus on what works for your business.
Get in touch for support with your business strategy.