What is Gross Margin?
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Gross margin is a finance term that seems to be defined differently by every company.
Gross Margin Defined
Gross profit is the money earned from a sale minus the direct costs of that sale.
Gross margin is gross profit expressed as a percentage of sales. However, some people will use the term gross margin to refer to gross profit i.e. expressed in a dollar amount.
Gross Margin Examples
Gross Margin Example 1
If you makes a sale of $100, but it costs you $40 in raw materials and labor, you have a gross profit of $60 and a gross margin of 60%. On the profit and loss (P&L) statement, you'll have a lot of other expenses below the gross margin, e.g. operating expenses, interest, and taxes.
So gross margin is not a complete picture of your profit; it only looks at the amount of money left after the direct costs of the sale. If you need a refresher on types of costs, check out our article "What Are Direct vs Indirect Costs?"
Gross Margin Example 2
You run a cleaning business, and you send a cleaner out to work at a place for a couple of hours. You plan to bill $50, but you'll pay the cleaner $20, and the cleaning supplies cost $4.
Direct costs do include:
- The cost of paying the cleaner.
- The cleaning supplies that were used.
Direct costs do not include:
- The cost of paying someone to answer the phone.
- The cost of advertising in the neighbourhood.
- The cost of a mob that will be used again.
Your direct costs are $24 out of the $50, leaving a $26 gross profit. Your gross margin is 52%. The remaining $26 is necessary to pay for the indirect costs, the receptionist, advertising, the mops—and your salary.
Why Is Gross Margin Important?
No company—not even a non-profit—can afford to have a gross margin of 0. Without a sufficient gross margin, a business cannot cover its indirect costs and it will eventually fail.
All employees need to understand gross margin and how their actions can affect the business financially.
At Income|Outcome, we believe in strengthening financial acumen so teams can understand gross margin and other key financial terms. Our corporate finance training simulations help employees make better business decisions and drive better results.
Contact us today to develop your team's financial acumen through engaging and effective training simulations!
