Gross Margin: How to Calculate and Use It for Business Growth
How to calculate gross margin
Below is the gross margin formula:
- returns and canceled orders;
- discounts and bonuses that reduce actual revenue;
- taxes, if included in the price (e.g., VAT), since they are not considered company income and do not affect profitability.
What is the difference between gross profit and gross margin
The gross profit formula is as follows:
For example, a business earned $1,000,000 in a month, while expenses for materials, production, and labor totaled $600,000. Here is how margin is calculated and how to find gross profit in this case:
- Gross profit = 1,000,000 – 600,000 = $400,000
- Gross margin = 400,000 / 1,000,000 × 100% = 40%
Gross margin reflects a business's operational efficiency more accurately, helping to correctly compare companies of different sizes. For example, two companies have the same gross profit of $400,000, but different revenues:
- with a revenue of $1,000,000, the margin is 40%;
- with a revenue of $2,000,000, only 20%.
Why calculate gross margin
Assessment of actual profitability
Revenue growth alone does not reflect gross profitability or business performance. If expenses increase along with sales, bottom-line profit may remain the same or even decline.
Margin shows what portion of revenue actually remains at the company's disposal. This helps distinguish between formal revenue growth and true profit growth and identify areas with the highest return.
Efficiency and cost monitoring
A declining margin is an early indicator that costs are increasing faster than revenue. Monitoring the indicator over time allows for timely adjustments to expenses, optimizing purchasing, and maintaining business profitability.
Basis for pricing
Knowing the desired margin level allows you to calculate the minimum selling price that will ensure profitability. This is done using the following formula:
The margin is expressed as a fraction of a unit (for example, for 20%, a value of 0.2 is used). If the cost of a product is $500 and the target margin is 40%, the minimum selling price is calculated as follows:
- Price = 500 / (1 – 0.4) = 833.33
Assortment and product strategy analysis
Product analysis reveals which products and services generate the most profit and which merely generate turnover. This data helps strengthen the product range by focusing on profitable categories and eliminating unprofitable areas.
Transparency for investors and partners
For banks and shareholders, gross margin is one of the most important indicators. It reflects how efficiently a company manages costs and maintains profitability. A stable or growing margin increases confidence in the business and demonstrates its financial stability.
What is considered a healthy gross margin
- Above 70% — indicates low variable costs and high product value. This level is typical, for example, for digital products with minimal production costs.
- 50–70% — indicates an optimal balance between cost and price. This is typical for branded products and specialized manufacturing.
- 30–50% — typical range for industries with moderate production costs, such as retail or catering.
- Below 30% — observed in highly competitive industries with limited room for maneuver, such as consumer goods.
However, these figures should be taken as a rough guide only. In real-world conditions, profitability and marginality are influenced by such factors as:
- cost structure: the greater the dependence on raw materials and logistics, the lower the margin;
- brand strength and positioning: well-known and sought-after brands can command higher prices;
- regional and tax conditions: a business's margins may vary significantly across countries and jurisdictions.
It is important to remember that an excessively high gross margin does not always indicate financial health. Sometimes this is the result of inflated prices, which increases the risk of losing customers when a more affordable alternative appears on the market.
Advantages and limitations of gross margin
| Advantages | Limitations |
|---|---|
| Quick efficiency assessment. Helps understand how efficiently a company is using its resources. Early identification of downward trends enables timely improvement measures. | Indirect costs are not taken into account. Covers only direct costs, excluding administrative expenses and marketing management. |
| Competitor comparison. Comparing gross margins helps determine which market players are more effective at managing costs and maintaining profitability under similar conditions. | Intermediate view of profitability. Margin is just the first level of analysis. Even a high figure does not guarantee overall profitability if a significant portion of revenue is spent on administrative and operating costs. |
| A basis for pricing and product assortment. Allows to determine the share of the most profitable products, develop a sustainable pricing strategy, and consciously shape a product portfolio. | Seasonality and structural fluctuations. Margins may change over time due to promotions, discounts, or the introduction of new product categories. Without taking these factors into account, the dynamics may be misinterpreted. |
| Sensitivity to changes in costs and revenue. Margin reacts to fluctuations in expenses and revenues more quickly than bottom line profit. Because of this, the metric serves as an indicator of the operational health of a business. | Not applicable for cross-industry comparisons. Comparing normal margin levels across different industries is not appropriate, as the differences can be significant. It is important to focus only on data for a specific industry. |
How to increase gross margin
Gross margin growth is not always associated with price increases. It is often achieved through systematic process optimization and proper product positioning.
Cost reduction
Even small cost adjustments may significantly improve financial results. For example, you may try the following:
- analyze expenses and eliminate unnecessary or duplicate items;
- use alternative materials or components that maintain quality;
- optimize logistics and delivery routes;
- automate routine operations to reduce manual labor.
Assortment management
To maintain margin, it is important to understand which products contribute most to the result. This is accomplished by analyzing SKUs, identifying the share of high-margin categories and products with low or negative returns. The resulting data is used in purchasing and promotion planning, with focus on areas with the highest profitability.
Reviewing pricing
Working with promotions and discounts
Discounts help attract attention to a product, but they also reduce gross margins. Therefore, it is important to use them consciously, as a sales growth tool:
- use promotions strategically, for example, to attract new customers or promote specific categories;
- limit the duration and frequency of discount campaigns;
- evaluate the effectiveness of promotions based on profit, not revenue.
Increasing product value
Sometimes the path to increasing margins lies not in cutting costs, but in strengthening brand perception. To do this:
- improve service quality and user experience;
- invest in design, reputation, and communications;
- emphasize the unique advantages of your product that customers are willing to pay more for.
When customers perceive an offer as truly valuable, price ceases to be a deciding factor. This is especially important for brands, services, and companies operating in the premium segment.
Conclusion
To put it simply, margin is one of those metrics without which it is impossible to determine whether a business is truly profitable. It helps determine whether the company has a "safety margin" and whether it is worth changing prices or revising its product line.
Gross margin serves as a starting point for analyzing a company's financial health: it assesses process efficiency, resilience to cost increases, and potential for scalability. The more closely a business monitors this metric, the more confidently it can manage profits and its development strategy.
