Understanding Gross Margins

Many owners leave the figures to “The Finance Manager” and/or look at the amount that the business owes and what is owed to them because that is all they feel they need to know.  It may be hard to believe even today that many owners do not show a great deal of interest or really understand what makes a business tick.  It is sales and cash in the bank which equals the real financial success.

The gross margin or gross profit percentage is a key indicator of the efficiency of a business using the raw materials and labour required for the production process.  Understanding such figures and comparing your business with others in the same industry will allow you to answer crucial questions regarding your business.  You will be able to identify whether or not you need to look at your pricing policy, if you are overstaffed/understaffed, or even if you need to look at the efficiency of the production team.

Rent & rates, utility costs, office wages, insurance costs etc all come under the category of Fixed Costs. These costs will remain similar each month and do not vary materially, except for say higher power and heating costs during the Winter months.

Then there are the variable costs, predominantly materials purchased and production or chargeable staff wages.  When looking at your business this is the area of prime interest to investigate.

Firstly, look at the sector in which the company operate and how does the business compare to the norm for the industry?  Then compare the figures from the business and calculate the cost income ratio for purchases as a percentage of sales and do the same for production or chargeable staff wages.  Look at the trend say over the past three years and identify any areas that require further investigation.  Such areas include:

  • Why are purchases as a percentage of sales showing an increase?
  • Have material costs increased and been passed on to the end buyer?
  • Is the difference between margin and mark up fully understood? (A mark up of 50% produces a gross profit or margin of 33% as gross profit is expressed as a percentage of sales not variable costs).
  • Are comparable materials available elsewhere at a cheaper price?
  • Has the business tried to negotiate better prices from the supplier?

As we also said, production labour or chargeable staff costs are also compared as a percentage of sales.  These will vary from industry to industry, for example retail and service industries will show higher labour costs than the manufacturing sector as they are more labour intensive.  Ask yourself:

  • Do you know and understand the true wage cost?
  • How many productive hours are there each year?
  • What is the true cost to the business and are the production or chargeable staff being utilised to the maximum efficiency level possible?
  • What factors do I need to build into the equation?
  • What is the norm for my business for wage costs compared to others in the same sector?

Remember to compare your business to other businesses in the same sector and continually benchmark performance.  Stay in touch with the financial side of the business, this is what will eventually reap the long-term rewards you are seeking.


If you have any queries or questions regarding Gross Margins, please feel free to get in touch with us via email enquiry@w-l-p.co.uk or via telephone 01953 882141.