I learn a lot from my five year old son. This morning I found one of his LEGO creations on the counter. When I grew up, my LEGO guys all had the right body parts, their heads were on straight, and everything made sense. The guy that my son built had all sorts of cool upgrades. This guy had a beak for a face, flames coming out of his ear, a hat full of gadgets and tools, and he was holding a flame thrower. This LEGO guy was way better than anything I built as a kid. Where was my imagination?!
As I looked at it, I found admiration for a child's creativity and a blog post began to swell in my mind. Today, we're going to talk about how to calculate gross margin, increase it, and be loved by your customers.
What does my son's LEGO creation have to do with learning how to calculate profit margin? Read on dear friend. Read on.
What is Gross Margin?
Gross margin is nothing more than a ratio. I will say this though - it's the most important ratio in your business. That's why successful business owners know their gross margins, how to calculate them, and how to improve them. Your gross margin tells you, in percentage format, how profitable your company is. For example, if your gross margin is 56%, that means that for every dollar you earn in sales, you spent 44 cents to make your product or service and you get to keep the other 56 cents to help pay for overhead.
How to Calculate Gross Margin
Learning how to calculate gross margin is easy. There is no need to pull out the dusty accounting books from your Uncle's bookshelf and prepare for a long day of boredom. Simply follow the three steps below and you'll be able to calculate your gross margin quickly.
- Add up all of the costs you incurred to make your product or service. These are the variable costs like materials, direct labor, etc.
- Subtract the costs calculated in step one from the price of your product or service. The resulting figure is your gross profit.
- Divide your gross profit (calculated in step 2) by the price tag of your product or service and you have your profit margin.
How to Increase Your Gross Margin
Alright, lets get back to LEGO man above. In business, there are two kinds of companies that win.
- Those that focus on product differentiation (Having the best product or service on the market)
- Those that focus on being the low cost leader (Having the cheapest product or service on the market)