There are many numbers small business owners should be aware of, but gross profit could very well be the most important one! You've been told many times before, "you should know your numbers." We agree with this statement, but take it a step further. Let's not only know our numbers, but more importantly, how to improve them!
What Is Gross Margin?
Gross margin is simply a ratio that tells you how profitable your company is, in a percentage format. For example, lets say you are in the construction industry and your gross margin is 60%. That means that for every dollar you earn in sales, you spent 40 cents to make your product or service and you get to keep the other 50 cents to help pay for overhead.
How Do You Calculate Gross Margin?
Learning how to calculate gross margin is simple! The numbers you will need can easily be found on your standard profit and loss statement. Follow these 3 steps to calculate your GM%:
Add up all of the costs incurred to make your product or service. These are your direct costs that can be attributed to a specific job. Labor and materials are the two most common.
Subtract the costs you calculated in step 1 from the price/revenue you received for that product or service. This gives you your gross profit.
To turn it into a margin percentage, take the number from step 2 and divide it by your price/revenue. This gives you your gross margin percentage.
Let's go through an example together. Say that you sell a product for $1,000. The labor, materials and other direct costs to make this product equals $400. Your gross profit is $1,000-$400 = $600. That means your gross margin is $600/$1,000 = 60%. So, for every dollar of that product you sell, you get to keep 60 cents to pay for overhead and make a profit!
How to Increase Your Gross Margin
Now that we know our gross margin, lets look at ways to improve it. Business' that are successful do so in one of two ways. They either build a better mouse trap (product differentiation) or they build a cheaper mouse trap (being the low cost provider).
Either strategy will work, but you must decide which one to pursue. If you choose to be the low cost provider, you must understand that you are counting on having a large volume of sales. A product differentiation approach allows you to command a premium and gives your business many different options. In our opinion, it is the better of the two!
Finding new and creative ways to build a better mouse trap allows you to raise prices and still retain customers. When customers understand that the value they are paying for is increasing, they are more than willing to accept the higher price. Take the iPhone for example. Apple does a wonderful job of implementing new technology into every new release (adding value) while simultaneously increasing the price. Customers are still lined up down the street to get the latest and greatest.
Conclusion
If you want to increase your gross margin, build a better mouse trap. This for small businesses can look like a lot of different things. Maybe it's quicker responses to customers. Bundling several products into a package. Or even starting a rewards program for frequent customers. Whatever you decide, simply make sure it adds value!
Comments