Importance of understanding your gross margins
The gross margin is more than a number. It is a window into the financial health of a company. It measures production and business efficiencies. It can help with setting the selling price of a product and competitive analysis. Gross margins can identify potential problems before they hurt the bottom line.
Gross margin gives critical information on production ROI
Evaluating gross margins over time can help with cost control. Minor changes in gross margin can highlight problems in the supply chain. Has the cost of materials increased, or has a supplier upped its price? Is it taking longer to deliver a service than anticipated?
Processes may need to be adjusted to improve productivity. It's easy to overlook minor inefficiencies as long as margins are high, but a drop in gross margin could signal a decline in productivity. The more efficient production, the higher the margins. The higher the margins, the healthier the company.
Gross margin helps inform pricing
Gross margins can be used to develop pricing strategies. Products are often priced based on market competition. Companies within a given market accept "standard" margins rather than explore pricing options.
Some businesses will decrease margins to increase gross sales in hopes of finding the perfect price point. Others will attempt to increase margins by setting higher prices, and marketing value adds. Careful analysis of gross margins can help triangulate the ideal pricing strategy to ensure higher profits and a healthy financial future.
Gross margin measures business efficiency
Gross margins can serve as a measure of company efficiency. If income statements are available on a monthly or quarterly basis, compare the gross margin figures. Are they staying steady? If margins are rising, that may be an indicator of improved efficiencies. A decline in gross margin may indicate inefficiencies. It can also indicate that lowering prices to increase sales is having a negative impact on financial stability.
Gross margin improves competitive analysis
Investors look at gross margin percentages to compare the profitability of companies from different market segments or industries. For example, analysts are looking at a manufacturing company and professional services groups for potential investment. Using the gross margin percentages from financial statements, analysts can determine any company's profit and learn which organization has stronger growth potential. High margins make it easier for companies to find additional funding.
Gross margin indicates growth potential
The gross margin amount indicates how much money a company has to invest in growing the business. If most of the gross profit is used to cover administrative expenses and operating costs, little money is available to enable growth. A lack of capital is one of the primary reasons that small businesses fail.