Gross margin is an ambiguous phrase that expresses the relationship between gross
profit and sales revenue. The ambiguity arises because it can be expressed in absolute
terms:
Or as the ratio of gross profit to sales revenue, usually in the form of a percentage:
In everyday speech the word 'percentage' is sometimes omitted and this can create confusion.
Note: "Cost of goods sold" are the costs directly linked to the product, variable
costs, e.g. costs for material and labor. They do not include 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 to use Gross Margin in Sales
Sales people often need to determine how much to charge a customer by marking up the cost of a product to arrive at the final
price. There are two basic methods but both give the same result - an indication of the gross profit of the sale. The two methods
express the result differently.
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 they would have to
use a markup of 1.5 or 50%. To calculate the price to the customer, you simply take the product cost of $100 and multiply it by
the markup arriving at the selling price of $150.
While we understand that we made a $50 profit on the example above, markup does not tell us directly what percentage of our
selling price is profit. If someone told you that they just sold a product for $339 at a 1.66 markup it is hard to directly
understand exactly how many dollars of profit was realized on the sale.
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 $150 price that includes a 50% markup represents a 33% gross margin. As you can see, gross margin is just the percentage
of the selling price that is profit. In this case 33% of our price is profit, or $50.
In the more complex example of $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) = 100% - (100% /(100% + Markup))
Examples:
- Markup = 100%
- GM = 100% - ( 100% / 200% ) = 50%
- Markup = 66%
- GM = 100% - ( 100% / 166% ) = 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 offers be a 40% gross margin minimum. This means that you as the sales person need to calculate the selling price using the
cost of the product and the required GM.
Formula to calculate Selling price using Gross Margin
Selling Price = Cost / (1-GM%)
For example, if your product costs $100 and the required gross margin is 40%, then your Selling Price = $100/(1-0.4) =
$100/0.6 = $166.6
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