Today’s word involves your profit—sort of.
“Gross margin” is one of those tricky terms defined differently by every business.
But at a basic level, “gross profit” is the money earned from a sale minus the direct costs of that sale and “gross margin” is gross profit expressed as a percentage of sales. However; some people prefer to use gross margin to mean gross profit–and it is expressed as $ or %.
Example: If you have sales of $100, but it costs you $40 in raw materials and labor, you’re left with a gross profit of $60, and a gross margin of 60% or $60.
On the P&L, you’ll have a lot of other expenses below the gross margin, e.g. operating expenses, interest, taxes. So a gross margin is not a full picture of your profit; it only looks at the amount of money left after the direct costs of the sale.
Example: 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’re going to pay the cleaner $20, and the cleaning supplies cost $4.
Your direct costs are $24 out of the $50, leaving $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 up.
Direct costs do not include:
- The cost of paying whenever answers the phones.
- The cost of advertising in the neighborhood.
- The cost of a mop that will be reused.
The $26 (52%) gross margin is necessary to pay for the receptionist, advertising, and mops—and your own salary.
Therefore no company, not even a non-profit, can afford to have 0 gross margin, or they will go out of business.
Also, take a look at this visual finance example of Google’s very healthy 67% gross margin.