A high gross margin is often viewed as the most important sign of a company in good financial health. Before you can earn net profit, you need to achieve a strong gross profit margin.

Calculating Gross Profit Margin

Gross profit margin is the portion of your company’s sales retained as profit after you account for costs of goods sold (aka COGS). COGS include direct costs in making or acquiring products for sale. To calculate gross margin, subtract COGS from periodic revenue; then, divide the resulting gross profit by the revenue.

Interpreting Your Margin

Gross margin performance isn’t a clear black and white issue. A 40 percent gross margin is very high in some industries, but average or below-average in others. More competitive industries tend to lead to lower overall gross margins for key players.

To assess your periodic gross margin performance, look for a couple key indicators. First, is your current gross profit margin up or down from the previous period? Over time, you want your margin to increase, or at least remain steady. Second, how does your profit margin compare to industry norms? Top providers have margins at or above industry norms.

Why High Gross Margin Matters

Gross profit is the first level of profit on an income statement. You have to remove fixed costs and account for irregular items to compute net profit. However, high gross profit is the starting point. A high gross margin shows efficiency in turning sales into profit.

A company that has a high gross margin ratio leaves more revenue on the table to cover fixed costs, and to achieve net profit. When your margins decline or fall short of industry standards, it is more difficult to keep up with overhead and achieve net profit. You need to achieve net profit to have funds to reinvest in business growth.

Conclusions

Make high growth margin a primary objective for your company. To do so means setting aggressive revenue goals and doing all you can to control COGS and fixed costs. When current gross margin is steady, review revenue and costs for any opportunities for improvement. If your gross margin is declining, more immediate action to drive better revenue performance and to cut costs is needed.