Margins, margins, margins. What’s the deal with margins? Why should you, as a business owner or manager, care about them?
Margins are the golden ticket in analyzing product sales. For most businesses that sell physical product, margins provide a meaningful way to evaluate sales and to ensure that they have priced their product to cover overhead costs.
Margins can be used to compare the sales of product and can be consistently evaluated over time, as well as over varying sales volumes. In addition, margins of your company can be compared to industry averages.
But what exactly are margins? How are they calculated?
When I refer to margins, I am mainly referring to your Gross Profit Margin (GP). Gross Profit Margin is calculated as Gross Profit divided by Gross Sales:
Gross Profit is calculated as Gross Sales less Cost of Goods Sold:
So, in other words, the Gross Profit Margin is calculating how much you are making in profit off every $1 in sales.
There are a few things to note to ensure that the margin is calculated appropriately. First, be sure that items that are included in cost of goods sold are truly the costs of the product that you are selling, and not what may actually be overhead costs. Also be sure that you have factored in all true costs.
For companies that are in the business of selling product for retail that they purchased from a supplier, it’s easy. For each item, the gross sale would be the sales price of the item, and the cost of good sold would be the cost to purchase the item.
For companies that are in the business of manufacturing a product, it’s a little more difficult. The gross sale of each item would be the sales price of the item, but the cost of goods sold would need to include all costs that went into making the item. This includes not only product costs, but also labor costs.
Note that the above explanations are fairly basic descriptions. With this post, I am not going to delve into the details of what is the correct cost of the items, which can differ depending on the inventory valuation method that your company is using. For purposes of this article, I am assuming you are starting with clean, clearly defined sales and cost of goods sold calculations.
In theory, the amount of gross profit is what you have left after selling the item to cover your company’s overhead costs.
You may be thinking, “That’s great – I just need to have higher and higher margins.” But watch out! Margins are largely dependent on the industry. If you are in a very competitive industry, simply raising your prices in order to attain a higher margin will not necessarily bode well for gross sales if you have customers jump ship to competitors.
Also note that the concept of margins is best looked at in comparison – either over time or to others in your industry. Given that the margin calculation is basically taking the result down to a per dollar factor, margins are helpful to examine over time, and can be consistent even with varying sales volumes.
Do be careful that you aren’t looking at your margin calculation in a vacuum. For example, it doesn’t make sense to just calculate it once and not compare it – that isn’t telling you anything! It also doesn’t help to compare your margin to other companies that aren’t in your industry. Margins can vary drastically among industries. (Growing up, I was directly exposed to the extremely slim margins that gas station owners face. Quick actions were necessary to make it in that business, with volatile price changes, extreme competition, and tight margins).
Overall, margins can be a very helpful tool to evaluate how your business is doing. In my experience, most industries have fairly consistent margins. An exception would be a business that is in a highly seasonal or cyclical industry or area. If your company is in a stable industry and area, margins that are jumping all over the place can be a sign that something is either wrong with the accounting process for recording inventory and cost of goods sold, or that there could be more fraudulent factors at play, such as theft of product.
Margins, margins, margins – an important tool for analyzing profitability of your sales. I love educating clients on this topic and helping solve issues with margins. Let me know how I can assist.