Gross Margin Is a Term That’s Often Misunderstood.
It’s essentially interchangeable with both gross profit and gross trading margin—and, sometimes, all three are misused. Then we expand on these terms adding the use of percentages and come up with the terms of gross margin percentage, gross profit percentage, and gross trading margin percentage. Then if you are not confused enough, we muddy the waters further with shorthand and acronyms of GM, GP, and GTMs and most people just glaze over.
Many small business owners do understand the concept of gross margin. However, the overwhelming majority do not understand how critical it is to track and measure their margins if they are going to maintain or increase profitability . And worse yet, even if they do understand, they have little idea how to build the accounting systems and metrics to track this vital part of business. Margin management is probably the single biggest opportunity to increase profits with existing sales. It is also the single biggest part of your business that can go south and erode profitability. Meaning, dropping a few percentage points in margin can have a dramatic effect on the bottom line. So where do we go from here?
Let’s unpack the concept of GM and GM% to build some clarity and a baseline understanding. Let’s start with the definition of GM and employ some basic accounting principles that you likely already know.
GROSS MARGIN (“GM”)
Sales minus Cost of Goods Sold equals Gross Margin:
|– Cost of Goods Sold||$97|
|= Gross Margin||$38|
|– Operating Expenses||$30|
Now, it gets more complicated when we start employing the concept of GM% and then track those percentages.
GROSS MARGIN % (“GM% ”)
Gross Margin divided by Sales (expressed as a percentage) equals Gross Margin %
Gross Margin ($38) / Sales ($135) = 28% (Gross Margin %)
The ability of a small business to track and measure GM% is crucial to maintaining or increasing profitability. It’s one of the most overlooked and valuable metrics in the small business universe. The majority of small business owners often rely on markup formulas or a “seat of the pants” approach to pricing and simply do not track their margins as a percentage of sales.
Let’s look at one more example. Your GM% slips by a few percentage ‘points’ from 28% to 26%. You think, it’s not great, but it’s only a few points, right? Now, look at the revised example with a reduction of two percentage points in GM%.
|– Cost of Goods Sold||$97||$100|
|= Gross Margin||$38 (28%)||$35 (26%)|
|– Cost of Goods Sold||$30||$30|
|= Profit||$8 (6%)||$5 (3.7%)|
Margins have only eroded by 2% but the profits of $8 are down to $5 or a reduction of 38%. Let that sink in for a minute.
No one is good enough to track a few points in margin erosion by gut feel. If your GM% is slipping, analysis of your pricing and costing structure, and applying targeted solutions is the only way to get back on track. You need to have the appropriate accounting systems and metrics in place.
Here’s the bad news. Your bookkeeper does not have the competence to track and analyze this phenomenon. If your accountant is your tax accountant, they are rarely focused on this issue and are not in the business of implementing these systems and metrics. You need a good small business accountant who can help you track margins by product line so you can make appropriate adjustments for the health of your company.
With our long years of experience being “in the trenches,” Resolution Accounting, using our CFO Advisory Services, is ready to help you gain control of your margins and get your company ready for what every small business wants–profitability and growth. We serve the entire Philadelphia region, including, King of Prussia, the Main Line, Malvern, Paoli, Exton, West Chester, all of Chester County, Montgomery County, Delaware County, and Bucks County.