How to Make the Most of Margins and Markups

When it comes to gross margins and the American economy, they vary widely throughout the country's industries. When New York University's Leonard N. Stern School of Business recently compiled gross margin statistics for January 2019, they found the low end includes the Auto and Truck industry with a gross margin of 11.45 percent and the Oilfield Services/Equipment industry with a gross margin of 10.70 percent. On the top end, the General and Diversified Real Estate industry saw a gross margin of 73.08 percent and the Investments and Asset Management industry saw a 70.67 percent gross margin. While these gross margins are divergent, understanding more about gross margins gives better context for understanding this measure.

Why Gross Margins Matter

One way to understand gross margins better is to understand how it's calculated. As the U.S. Small Business Administration (SBA) explains, the gross margin is expressed as a percentage. It's determined by taking the Costs of Goods sold from the company's overall revenue. The resulting figure is then divided by the original revenue number. It's also done over a specific time frame such as a single quarter, a calendar year or an internal fiscal year.

As the SBA explains, gross margins show what portion of the overall sales a business keeps after accounting for the Cost of Goods Sold, or whatever direct costs the good or service took to get ready for sale. Naturally, the higher the percentage, the more profitable the product or service. Regardless of the percentage, it's important to perform this analysis because it can show where there are efficiencies or inefficiencies in the good or service.

The SBA points out that gross margin is an important factor in determining how to price a product or service to ensure its profitability. For example, with recent developments on steel and aluminum tariffs, businesses that use these two raw materials would likely have to recalculate their costs and therefore gross margins, due to tariff rate changes.

With Section 232 tariffs no longer imposed on aluminum and steel from Canada and Mexico as of May 19, 2019, according to U.S. Customs and Border Protection, companies using this steel would need to see how this impacts their Cost of Goods Sold, and therefore gross margin.

There are many factors beyond this to account for when determining the final price for wholesale or retail. The SBA gives examples of what also influences a business' pricing strategy, such as transportation costs, seasonal demand, how customers see the worth of a product or service and how badly a company wants to make a name for itself against other business' products or services.      

While the SBA's general target for a gross margin is 45 percent (meaning the retail price of the good or service covers the Cost of Goods Sold, plus a 45 percent premium), it can act as a general guide. In addition, there are strategies that businesses can employ to work around various economic conditions.

Increase Efficiency

Increasing efficiency can take the place of investing in technology. With the advent of self-checkout technology and using mobile apps, we have reduced the need for cashiers in the retail/grocery industry. Over the long term, this will reduce the costs for labor. While this might not contribute to the cost of goods or services directly, it can reduce overhead in the long haul for retailers, offsetting a lower gross margin.

Maintain Current Prices (at least temporarily)

In the case of steel and aluminum tariffs, companies can benefit. With tariffs recently lifted on imported metals from Mexico and Canada, companies will be able to maintain current retail prices in the short term, thereby increasing margins.

While each industry has different gross margins, doing a financial analysis will give a business its true financial picture.

Sources

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/margin.html

https://www.sba.gov/blogs/understanding-gross-margin

https://www.cbp.gov/trade/remedies/232-tariffs-aluminum-and-steel

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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