What Does Gross Margin Mean Exactly? How do you Calculate it?

If you are an independent retailer, a good understanding of your business’s financial health will give you an edge in the competitive world. Gross profit margin is one of the key metrics that would help you make informed decisions that can elevate your business’s profitability.

Whether you’re new to the concept or just need a refresher, this guide will provide you with the tools and knowledge to effectively manage your retail business finances.

In this step-by-step guide, we’ll break down the process of calculating gross margin for independent retailers.

What is Gross Margin?

Gross margin is a financial metric that reflects the difference between a company’s revenue and cost of goods sold (COGS), such as inventory purchases, or materials and labor.

It’s a vital profitability measure as it shows how well a company manages its inventory purchasing costs compared to sales revenue.

Simply put, subtracting the cost of goods sold from revenue gives you the gross profit. A higher gross profit margin means more revenue retained by the company.

This revenue can be used to pay general and administrative expenses, interest fees, or meet debt obligations.

A Step-by-Step Guide To Calculating Gross Margin For Independent Retailers

Step 1: Determine Your Total Revenue

Total revenue, also known as sales, is the total amount of money earned from selling your products. This figure can be found on your income statement, or point of sales reports.

Formula: Total Revenue = Selling Price per Unit x Number of Units Sold

Calculation Example

For example, if you sell 100 items at $20 each, your total revenue is $2,000.

Step 2: Calculate the Cost of Goods Sold (COGS)

COGS includes all the direct costs associated with producing or purchasing the products you sell. This typically includes the goods you buy from your vendors, or suppliers, and the freight cost.

Formula: COGS = Beginning Inventory + Purchases During the Period – Ending Inventory

Calculation Example

For instance, if you started with $500 worth of inventory, bought an additional $1,000 worth of goods, and ended with $300 worth of inventory, your COGS is $1,200.

Step 3: Subtract COGS from Total Revenue to Get Gross Profit

Gross profit is the amount of money you make after subtracting the costs directly tied to purchasing or producing your products.

Formula: Gross Profit = Total Revenue – COGS

Calculation Example

Using our previous examples, if your total revenue is $2,000 and your COGS is $1,200, your gross profit is $800.

Step 4: Calculating Gross Margin

To calculate the gross profit margin, take net sales minus the COGS.

Formula: Gross Margin = Net Sales – COGS

Net sales are equivalent to revenue generated from sales for a certain period. COGS comprises the cost of the merchandise purchased from vendors and freight expense.

Calculation Example

Continuing with our example, if your gross profit is $800 and your total revenue is $2,000, your gross margin is (800 / 2000) x 100 = 40%.

This is a critical factor for independent retailers, the Inventory Reality Check workbook will walk the store owner, or buyer through this calculation for the merchandise categories and vendors. At the end of the exercise, you will know the aspects of your inventory contributing to your success and those that are not. Click the link and download the workbook today.

Step 5: Interpreting Gross Margin Results

Insights into Profitability and Efficiency

A company with a high gross margin means the sales exceed the direct costs of inventory purchases and freight. This indicates that the company is producing and selling its products efficiently at a reasonable price. With a higher gross margin ratio, the company can have the following:

• Improved Cash Flow: A higher gross margin allows the store owner to improve their cash position.
• Competitive Advantage: A higher margin reflects the company’s edge over competitors through better pricing or more efficient operations.

Identifying Areas for Improvement

A company with a low gross margin might need help sourcing its goods, setting prices, or managing costs.

The company needs to look into these areas to improve and make more profit.

• High Supplier Costs: The cost of sourcing products might be too high, and the company needs to find ways to cut these costs.
• Pricing Issues: Prices might be too low to cover expenses, and the company might need to rethink its pricing strategy.
• Product Quality or Demand Issues: Products that need to sell better are often returned, lowering the gross margin.
• Cost Management: The company might need to look into better ways to manage its overall costs, including materials, labor, and overhead.

Download the Inventory Realty Check today. Upon completion, you will know which vendors and merchandise categories are weighing down the store’s gross margin. to try it out.

Gross Profit Margin: A Deeper Dive

Understanding Gross Margin vs. Net Profit Margin

Learn more about Mastering The Profit Margin Formula: What Business Owners Must Know

Understanding Gross Profit vs. Gross Profit Margin

Gross margin and gross profit are financial metrics that companies use to measure their profitability. Notably, these figures are an important part of the financial statements, income statements to be specific.

Commonly used interchangeably, these two figures are different.

Key Differences Between Gross Profit and Gross Margin

• Gross Profit is expressed in dollars, showing the total amount of profit after subtracting COGS from revenue.
• Gross Margin is expressed as a percentage, showing how much of each dollar of revenue is profit after COGS.

Factors Affecting Gross Margin

1. Cost of Goods Sold (COGS)

Sales Volume: An increase in sales results in higher gross margins especially if the company has fixed costs of the goods sold.

Inventory: If the vendors increase the cost, the COGS sold goes up. Unforeseen factors such as weather conditions and political unrest are beyond control. To keep a check on COGS it is better to have multiple suppliers. 

2. Pricing Strategy

Product Pricing: A company’s pricing of its products relative to purchasing, or production costs directly affects the gross margin.

Discounts and Promotions: Offering discounts or promotions often can lower the gross margin.

Market Positioning: Premium pricing for high-quality or distinctive products can increase gross margins.

3. Supply Chain Management

Supplier Relationships: Strong ties with the suppliers can lead to better pricing and terms, eventually reducing COGS.

Inventory Management: Efficient inventory management can minimize holding costs and reduce waste, positively impacting gross margin.

Automation and Technology: Investment in technology and automation can significantly reduce production costs and improve gross margin.

Waste Reduction: Optimization of resources and minimizing waste leads to lower COGS, enhancing gross margin.

Quality Control: High-quality products yield fewer returns and defects, maintaining a healthier gross margin.

Strategies for Increasing Gross Margin

Increase Revenue

Expand Customer Base: Explore new markets or demographics to increase sales.

Increase Purchase Volume: Encourage existing customers to buy more through enticing offers, loyalty programs, promotions, and improved customer service.

Decrease Cost of Goods Sold (COGS)

Reduce Materials Costs: Negotiate with the suppliers or find alternative materials at better prices.

Invest in Automation: Automate the repetitive tasks with robotics, and use efficient software solutions. 

Assess Product Profitability: Shift your focus to products that deliver the best profit and consider cutting those that perform poorly. To identify which vendors and merchandise categories boost the store’s gross margin and that weigh down the store’s gross margin, download the Inventory Realty Check workbook today.

Gross Margin Insights: Integrating Gross Margin into Your Business Strategy

Informed Decisions

Gaining gross margin insights helps you make intelligent business choices. You can make better decisions about pricing your products if you understand how much profit you can achieve from your sales after covering production costs.

Moreover, when you integrate gross margin into your business model, you can better understand how much you should produce. You can adjust production levels efficiently to ensure you are not overspending on materials or labor.

You can use gross margin data to set prices that yield maximum profit while staying competitive. Further, when you make informed decisions, you are better positioned to decide where your investment money should go. Allocating funds to improve efficiency and increase profitability is wise.

Regular Monitoring

The key to staying profitable is regularly checking your gross margin. When you persistently track this metric, you can spot issues quickly and rectify them instantly. If your gross profit margin drops, it might indicate rising costs and decreasing sales. Regularly reviewing inventory reports and receiving journals will help you identify data entry errors that can be corrected. Moreover, it would help to compare gross margins with industry benchmarks to avoid misinterpretations.

Moreover, monitoring things regularly increases your likelihood of reducing costs and increasing efficiency. When you keep your gross profit margin in check, you can ensure that the business model is on the right track and that you stay competitive in the market with balanced prices.

Conclusion

We have established that gross profit margins are important to measure a retail store’s ability to retain revenue after deducting direct expenses. Accurately calculating the gross profit margin ratio will help you make informed decisions for your business.

All in all, you need to know your numbers to improve your store’s profitability. You can only do that if you understand the components contributing to profitability. Completing the Inventory Realty Check workbook can shed light on your gross margin, but as a store owner, you may not  have time to complete it?

It is easy to put off tasks that will benefit your business in the long run because there’s always so much going on. If this is true for you, I have an offer for you!

Get a Free Inventory Evaluation

Whether your business has been open for one year or ten, the savvy indie retailer always looks for ways to improve, make progress, and grow their business. 

It doesn’t matter where you are in your journey of entrepreneurship. Whether all of this is new to you or if you’ve been at it awhile, an objective Inventory Evaluation will provide:

• Outside eyes to see the potential in the business.
• Determinations about any obstacles to manifesting that potential, any red flags that require immediate attention, or what additional resources may be necessary to help you, the owner, build the desired value. 
• Outside eyes to confirm that you are taking the right steps toward the solution.

Want to learn more about open-to-buy, identify any roadblocks in your business, and address them as quickly as possible? Click here to schedule a strategy call with me.

To Your Improvement, Progress, and Growth!

Audrey