Gross margin is a finance term that seems to be defined differently by every company.
Gross Margin Defined
Gross margin is gross profit expressed as a percentage of sales. Gross profit is the money earned from a sale minus the direct costs of that sale. Sometimes people will use the term gross margin to refer to gross profit, expressed in a dollar amount or as a percentage.
Gross Margin Examples
Gross Margin Example 1
If you have sales of $100, but it costs you $40 in raw materials and labor, you have a gross margin of $60 or 60% and a gross profit 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 a 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. Your direct costs are $24 out of the $50, leaving a $26 gross profit. Your gross margin is 52%, or $26.
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 phones.
- The cost of advertising in the neighborhood.
- The cost of a mop that will be used again.
The $26 (52%) gross margin is necessary to pay for the indirect costs, the receptionist, advertising, and mops—and your salary.
Why Is Gross Margin Important?
No company, not even a non-profit, can afford to have no gross margin. Without a high enough gross margin, a company will not be viable for long. They will go out of business as they will not have the funds to pay the business’s indirect costs.
All employees need to understand gross margin and how their actions can affect the business financially. It’s essential that there is a common language and employees use the term gross margin to refer to the same number to avoid miscommunication.
At Income|Outcome, we believe in building your team’s financial acumen so that they can understand gross margin and other key financial terms. Income|Outcome offers corporate finance acumen training simulations to upskill employees’ business acumen, allowing them to make better decisions and achieve better results for your business.