A critical issue for any business is pricing its products. A price that's too high may drive customers to your competitors. Set prices too low and you lose out on profit. Worse, you may fail to cover your costs. Gross margin percentage tells you how much of each dollar in sales is available to pay those business expenses and provide a reasonable profit.
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Gross margin is the difference between the cost of a good or service and its price. The gross margin percentage tells you the proportion of the sales revenue represented by the gross margin. Depending on your needs, you can calculate gross margin percentage for a single product or for a business as a whole.
Before you can calculate gross margin percentage, you have to figure out the cost of goods or services. For some types of business this is a straightforward matter. For example, the cost of goods for a retail shop is usually the cost of inventory plus an allowance for damaged or lost items. By contrast, a manufacturer has to account for the cost of all raw materials plus the cost of direct labour; that is, the labour used to actually make a product.
Once you determine the cost of goods or services, subtract it from the sale price to calculate the gross margin in dollars. To calculate gross margin percentage, divide the gross margin in dollars by the sale price and multiply by 100. For example, if one unit costs £9 and the sale price is £16, your gross margin is £16 minus £9, or £6. Divide £6 by £16 and multiply the result by 100. In this example, the gross margin percentage is 40 per cent.
Gross margin percentage is closely related to another measure used in business called markup. Markup is the percentage of the cost of a good or service that is added to that cost to arrive at a price. Businesses frequently set up markup formulas to simplify pricing. Suppose a product costs £6 and the markup is set at 100 per cent. You would add 100 per cent of £6 to the cost of £6 to arrive at a price of £13. The added £6 is the gross margin and represents a gross margin percentage of 50 per cent.
Although they are similar, gross margin percentage and markup have different uses. Markup formulas take the guesswork out of choosing a price. Gross margin and gross margin percentage are useful for cost analysis in a number of ways. For example, if you find the gross margin percentage is not high enough to cover the percentage of overhead and other business expenses, you know you need to adjust the item's price upward. Another example is using gross margin to guide you in setting discounts and markdowns. Cutting a price to attract more customers is good business strategy. However, you don't want to cut the price so much your gross margin percentage is too small for you to show a profit.
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