Do You Know Your Gross Margin?

Gross margin shows how much money remains after subtracting the direct costs involved in providing your products or services.

These direct costs are often referred to as the cost of sales or cost of goods sold.

The basic calculation is:

Gross profit = Revenue – Cost of sales

Gross margin is then expressed as a percentage:

Gross margin percentage = Gross profit ÷ Revenue × 100

For example, imagine your business generates £100,000 in revenue and has direct costs of £60,000.

Your gross profit would be £40,000, giving you a gross margin of 40%.

This means that for every £1 of revenue, 40p remains to cover overheads such as salaries, rent, software, marketing and administration, before producing a final net profit.

Revenue alone does not tell you whether your business model is profitable.

A company may increase sales significantly but still struggle financially if the cost of delivering those sales rises at the same rate—or faster.

Tracking gross margin helps you understand whether your core activities are generating enough profit to support the wider business.

It can help you answer important questions such as:

• Are your prices high enough?
• Are supplier or production costs increasing?
• Which products or services are most profitable?
• Are discounts reducing your profitability?
• Can the business afford to hire, invest or expand?

A healthy gross margin gives your business more room to absorb overheads, manage unexpected costs and invest in future growth.

Gross profit is the amount of money left after direct costs have been deducted.

Gross margin expresses that amount as a percentage of revenue.

Both figures are useful, but the percentage often makes comparisons easier.

For example, your gross profit may increase as sales rise, but your gross margin percentage could still fall. This may indicate that your costs are increasing, your pricing is weakening or your sales mix is changing.

Looking only at the cash figure could hide this decline in performance.

Improving gross margin does not always mean increasing prices. It is often the result of several smaller improvements.

Here's a few things we recommend within your Xero software, and as part of your management accounts process:

Gross margin should not be something you calculate once a year when your accounts are prepared.

For many businesses, it should be reviewed quarterly, or even monthly.