Understanding your Gross Margin in 4 Easy Looks

No doubt an early stage business is concerned with sales and bringing in the money (revenue.) This frustration can be ever consuming with many entrepreneurs having lost sleep with ambiguity in executing a strategic plan.

Here are 4 easy steps to take to make sure your margin is in the right positioning to move your company forward. 

  1. How to quickly calculate Gross Margin.
  2. Understand the difference in Gross Margin vs. Gross Profit.
  3. How to identify norms of your Gross Margin
  4. Cautions of Manipulating your Gross Margin

First things first, every business needs to collect money (revenue) and pay expenses (taxes, payroll, insurance, vehicles, equipment, and other outgoing monies). These numbers are captured on a Balance Sheet, Income Statement, and Cashflow Statement. All three of these are and will be important for growing your company in a calculated way a though, this can be a larger discussion on business planning for later.  The main indicator of success though is not just revenue coming in and money going out; it is understanding the relationship between the two is Gross Margin.

For quick discussion – Formula for Gross Margin

((Revenue – Cost of Goods Sold)/Revenue)X100=Gross Margin

Here are a couple of definitions to consider:

  1. Revenue – all monies coming in
  2. Costs of Goods Sold – all costs used to create a product or service which is then sold (direct labor, materials, overhead)  

Now the fun part, how this reads in an example.  Company X receives $1000 for a job completed (revenue), however the work and tools and overhead cost $900 (cost of goods sold). 

 ———————- X 100  = 10% gross margin 

Not great, but it’s money coming in.  And your margin could be different for different segments in the cleaning industry.  Schools may be less.  Hospitals will be more.  Factories will be different too, and so on.  The key here to look at is that it is NOT in the red. (step one)

Next, why is it important to know this number instead of just looking at profit? This leads to a quick study of Profit (any revenue coming in above the cost of service).  As your company evolves you may need financing and profit for one industry to another is different.  What is good or bad is up for debate.  So the finance professionals have devised Gross Margin to be able to compare businesses to other businesses without needing to really know the businesses well.  

This is an advantage for your business because that controls your development to two factors, Revenue and Cost of Goods Sold.  Does that answer the question of what is the difference between Gross Profit and Gross Revenue?  Many around you may comment on your profits as being too high.  Your employees, your sales staff, your customers, and others will be talking about profit. 

Here’s the difference, if company X (like in the above example) did the work for $900 and charged $1000, that is $100 profit right? It would seem so, however the profit margin is 11%, not ten.  Why? Because profit and margin are figured differently. 

———- X 100 = profit margin

This may seem like semantics, however gross margin allows you to communicate with the banking world more efficiently and helps you plan more effectively for your yearly goals. 

Third, identifying your norms for your gross margins.  Instead of looking at profits, gross margins help you normalize your actions in different segments.  It helps you, or your sales staff, project confident bids because they will know what a safe zone is to calculate. It also identifies projects that you might consider declining.

These norms in gross margin can be quickly identified in your Income Statement (top line) as well as the Cost of Goods Sold (Income Statement, located just below the Revenue). The great thing is that your company’s gross margin can be broken down per client to help you identify which clients are great clients and which ones are depleting your resources (those should be the “No” customers). 

Finally, once you are armed with some practice of finding this number, you can now begin to drive progress.  There is a caution to this, like in Spiderman “with great power comes great responsibility” – once you see the levers of how banks and customers see your company you can start to dial in even more.  Be cautious not to invoke demands on either side of the equation without thinking about the unintended consequences of actions.  For instance, you could reduce staff by laying off an employee to save on Cost of Goods Sold, which would raise your margin, but that might increase employee turnover which will decrease client satisfaction and lose client revenue. 

The good unintended consequence is that it adds a depth of what you are trying to achieve. For instance, if you want to get a larger job you may need to get a loan for initial costs.  You now have the numbers they will be looking for and appear professional and confident.  This knowledge portrays to clients and banks that you have a handle on your business.  

This understanding also helps you identify other needs for your business, such as the need for a software to track all of this information for you.  Pulse and Bid, for example, can do these projections and calculations for you. Imagine going to a bank and already know what your year end should look like in Gross Margin.

The bank will have strong faith in your proposal and will be left with a lasting impression.

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