This is part 2 of Ravit Insights series on the 7 Cash Flow Drivers essential for SMEs.
Image credit: Brett Jordan via Unsplash
Money goes in and out of a business so quickly, sometimes it can be hard to know how much you are actually making or if you’re doing well.
Working out how much it costs you directly to sell your product or service is essentially what we mean when we talk about gross margins.
Maintaining gross margin is important. This means managing direct costs and ensuring you don’t provide too many “sales / discounts”. If you don’t keep track, the costs of selling your services can become one of those things where, while it might increase the top line, you may actually lose money doing it.
Cash flow positive: In general, the higher your gross margin, the better your cash flow.
How do you calculate it?
You can calculate Gross Margin in Dollars with the following formula:
Gross Margin $ = Revenue – Cost of Goods Sold
But you’ll most often see this as a percentage.
Gross Margin % = (Total Revenue – Cost of Goods Sold)/Total Revenue x 100
In non-finance terms, this is how much money is left over after the sale. This will go towards your other costs of running the business.
To use an example:
Just over a year ago, Jessica started an online business selling snowboards. She wants to get an idea of how her business did last year before the ski season starts in Australia and NZ. Using her accounting software she finds the figures she needs.
Her total revenue for the year was $350,000.
The costs of the good sold is $290,000. To find this figure it includes the direct cost of producing the goods such as labour, materials and manufacturing.
To calculate her gross margin she follows the formula:
Revenue – COGS = Gross Margin
$350,000 – $290,000 = $60,000
If she needs this as a percentage she continues the formula:
Gross Margin % = (Total Revenue – Cost of Goods Sold)/Total Revenue x 100
($350,000 – $290,000)/$350,000 x 100 = 17.14%
What is a good gross profit margin?
A good gross profit margin depends heavily on your industry. An industry like hospitality runs on tight margins to remain competitive, however too often these are unsustainable as was shown in the early days of the pandemic with some businesses immediately forced to close.
Service based businesses have higher gross profit margins as they do not involve manufacturing, but on the flip side are often harder to scale.
Gross margins for service-based business should be around 65%. There is a rule of thumb for service business, which is: Billable staff should generate roughly 3x their cost, 1x to cover salaries & wages, 1x to cover operating expenditure and the last 1x is left for profit.
A “good” gross margin will also depend on the type of company you run. For example, startups need to show good gross margins. With tech companies you’d expect in the 80%+. Once you factor in things like sales and advertising, this quickly plummets, but the gross margin to deliver the product should be very strong.
A larger business will operate at a high volume, and despite smaller margins still has the opportunity to create more profit.
What does understanding your gross margin mean?
A gross margin will help you understand if your business is running well, particularly if you are following its changes over time.
If your gross margin is falling, you may need to look at labour or production costs, or simply increasing the price of your goods.
If it is rising, it’s generally a good news story.
Gross margin vs net margin
Your gross margin is the relationship between revenue and the direct cost of the good or services.
Net margin will take into account all other indirect costs, which could include staff, administration costs, marketing, distribution and tax.
You’ll use the former to make sure your goods or services are profitable, while the latter will tell you how your company is performing as a whole.
Gross margin is just one of the seven cash flow drivers all business owners should understand.
