Understanding Gross Margin and How it Can Make or Break Your StartupOutside Contributor
Landscape Today: This article is from the Small Business Administration – Caron Beesley is a contributing writer to the SBA. Please see our article about how reducing price by only a few percentage points dramatically impacts your gross margin.
It may sound obvious, but understanding gross margin is often overlooked by startups and new business owners. This can have a direct impact on your ability to effectively manage a growing business, price your products, and most importantly, make a profit.
What is Gross Margin?
Put simply, gross margin is the money left after you have covered all the variable (not fixed) costs associated with the sale of a product or service (such as wages, materials, etc.). But gross margin is so much more than that; it is a measure of your production efficiencies and it determines your break even point. It is a key calculation as you assess your startup business risk and profitability.
To understand the impact gross margin has on profitability, consider this example:
A startup has $100,000 in fixed overhead costs with a projected gross margin of 50 percent of sales. To cover its overhead and break even, the startup would need to reach sales of $200,000.
However, with the help of cheaper suppliers and materials (or a higher unit price) gross margins may increase to 55 percent of sales, meaning the startup would need to sell less products or services before breaking even.
The Consequences of Not Knowing your Gross Margin
Understanding and monitoring gross margins can also help business owners avoid pricing problems, losing money on sales, and ultimately stay in business. If you don’t know what your gross margin is, then making sense of anomalies in your income statements becomes tricky. Why?
Many businesses that appear to be thriving often fail because their prices are too low or their costs are too high and they can’t make a profit. Establishing a low price strategy is tempting, especially when dealing with cut-throat competition – however, it’s rarely sustainable and it can be tough to increase prices later, even with a loyal customer base. Using gross margin calculations and other factors (discussed in more detail below) as you plan your business can help you avoid pricing mistakes before it’s too late.
Cost control is another area that can trip up small business owners. It’s surprisingly easy for staff to ignore cost control procedures, which can quickly erode your margins. For example, if higher cost materials have made their way into your production process (and this could be something as simple as a chef using a higher quality food product or making bigger sandwiches in the kitchen than had been budgeted for) – then you have a problem.
Knowing what your gross margin is on every product throughout the life cycle of your business and acting on any variations you detect can help you identify these problems before it’s too late.
How to Calculate Your Gross Margin
Calculating gross margin is easy if you’ve been in business long enough to get some recordkeeping under your belt, but for startups the process is a little more complex.
1) Calculating Gross Margin if You’ve Been in Business a While – Start by looking at historical data over a business quarter or year and identifying your company’s total revenue for this period and the costs of goods sold (raw materials and labor). Then follow this formula:
a) Subtract the costs of goods sold from the total revenue. In our example, subtract $100,000 from $200,000 to get $100,000.
b) Then divide the result from step one ($100,000) by the revenue ($200,000) to calculate gross margin = 0.5 or 50 percent.
You can also find a variety of online calculators to help you make this calculation.
2) Calculating Gross Margin as a Startup – If you don’t have any income reports to go by, calculating your potential gross margins involves some research. Consider the following:
- What is the competition doing? If you can, try to find out the gross margins of your competitors or industry averages to benchmark where yours should be. Even if their financial data is not in the public domain, their pricing and your understanding of costs will give you a rough estimate as to where your margins should be.
- Assess your costs and explore ways you can decrease these over time. This should give you an early indication of the profitability of your business. Remember that gross margins change over time through reduced costs and increased efficiencies.
Using Gross Margin to Calculate Product Pricing
While understanding gross margin can help you avoid pricing and cost control nightmares, should you be using it to calculate pricing? Many businesses go this route because it clearly expresses how many of your sales dollars are profit. However, many other factors help determine your pricing strategy, including potential market share, distribution costs, seasonal considerations, perceived value, and more. Read more about these in Pricing your Product or Service from SCORE.