Gross margin, Gross profit margin or Gross Profit Rate is the difference between the sales and the production costs (excluding the overheads). Gross margin can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and sales revenue.
It can be expressed in absolute terms:
Gross margin= Net Sales - Cost of Sales+ annual sales return
or as the ratio of gross profit to sales revenue, usually in the form of a percentage:
Gross Margin Percentage = (Revenue-Cost of Sales)/Revenue
Cost of Sales includes variable costs and fixed costs directly linked to the sale, such as material and labor. It does not include indirect fixed costs like office expenses, rent, administrative costs, etc.
Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer it will be their markup over wholesale. Larger gross margins are generally good for companies, with the exception of discount retailers. They need to show that operations efficiency and financing allows them to operate with tiny margins.
How gross margin is used in sales
Retailers can measure their profit by using two basic methods, markup and margin, both give a description of the gross profit of the sale. The markup expresses profit as a percentage of the retailer's cost for the product. The margin expresses profit as a percentage of the retailer's sales price for the product. These two methods give different percentages as results, but both percentages are valid descriptions of the retailer's profit. It is important to specify which method you are using when you refer to a retailer's profit as a percentage.
Some retailers use margins because you can easily calculate profits from a sales total. If your margin is 30%, then 30% of your sales total is profit. If your markup is 30%, the percentage of your 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 using markups. If your markup is 40%, then your sales price will be 40% above the item cost. If your margin is 40%, your sales price will not be 40% over cost.
Markup
Markup can be expressed either as a decimal or as a percentage, but is used as a multiplier. Here is an example:
If a product costs the company $100 to make and they wish to make a 50% profit on the sale of the product (sale dollars) they would have to use a markup of 100%. To calculate the price to the customer, you simply take the product cost of $100 and multiply it by (1 + the markup), eg: 1+1=2, arriving at the selling price of $200.
Gross margin
Most people find it easier to work with Gross Margin because it directly tells you how many of your sale dollars are profit. In reference to the two examples above:
The $200 price that includes a 100% markup represents a 50% gross margin. As you can see, gross margin is just the percentage of the selling price that is profit. In this case 50% of our price is profit, or $100.
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In the more complex example of selling price $339, a markup of 66% represents approximately a 40% gross margin. This means that 40% of the $339 is profit. Again, gross margin is just the direct percentage of profit in your 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 must be deducted.
Converting between gross margin (GM) and markup
The formula to convert a Markup to Gross Margin is:
Gross Margin (GM) = [Markup/(1 + Markup)]
Examples:
- Markup = 100%
- GM = [1 / (1 + 1)] = 0.5 = 50%
- Markup = 66%
- GM = [0.66 / (1 + 0.66)] = 0.398 = 39.8%
Using gross margin to calculate your selling price
Sometimes a salesperson will be asked to use gross margin in their sales. For example, your sales manager may ask that all sales include the cost of the product and the required GM.
Formula to calculate Selling price using gross margin
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- Selling Price
For example, if your product costs $100 and the required gross margin is 40%, then
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- Selling Price
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 development, since the cost of duplication is negligible, the gross profit margin can be higher than 80% in many cases.
