Gross Margin - The Potential for Profit
The next line on a P&L is gross profit. Subtract COGS from net sales and you have gross profit. This number is frequently referred to as gross margin and is expressed as a percentage.
This is the profit you made from doing what you do. If you manufacture, this is what you made maufacturing. If you provide a service, this is what you made providing that service. Gross profit does not reflect other indirect expenses that the business incurs. Such expenses are not a direct cost of producing goods or services. Indirect expenses are accounted for later, before we get to the bottom line. Gross profit reflects the profit made from your principal business activity. It focuses your attention on the result you achieved. Profit and cash can be generated by selling an asset. However, such a transaction has nothing to do with your principal business activity.
Businesses with a high gross margin have a better chance of being profitable than businesses with a lower margin. High margin businesses are more likely to have money left over to reinvest in the business, to spend on research and development, and for marketing expenditures. Reinvesting in the business and making marketing expenditures are hallmarks of great businesses. All things being equal, you would want to be in a high margin business rather than a low margin business. A grocery store is an example of a low margin business, while a jewelry store is an example of a high margin business. In broad terms, a high margin would be 50% or better and a low margin would be 10% or less. However, in some industries 10% would be high. Your industry trade association is a good source of such information.
For example, if you are in the grocery store business because you are good at it and it's your passion, you can still make a boat load of money, reinvest, and spend lavishly on marketing. It's just harder to do it in the grocery store business. You have to be a good operator to survive and prosper. The margin for error is much more critical in a low margin business too. A few mistakes or one huge error in judgement could put you out of business. These things are less of an issue in the high margin business.
Sales volume is a factor that has to be considered too. A low margin business with millions of dollars in sales can still provide a great deal of profit and cash at the end of the day, albeit a small percentage of sales. Conversely, a high margin business with a low volume may produce a huge margin but only a few dollars in profit.
Improving gross margin where that is possible is certainly a goal that management should embrace, particularly where it is low. Likewise, even a high margin business would want to increase its margin. However, maintaining it is certainly something management should be intent upon. The truth is , sometimes you just can't do much to increase the gross margin. The nature of the business you are in may only yield low margins. If so, you want to do all you can to increase sales volume.
High margin businesses should be generating solid net profits regularly and generating cash for reinvestment, marketing and overall improvement to the business. It can also be used to reward employees, management and owners. High gross profit is a predictor that net profit and cash generation should follow. If this isn't the case, you need to get this under discussion and investigate. In a low margin business you need to focus on maintaining and/or increasing sales volume.
