How do you use gross margin percentage (GM%) or gross profit percentage to run your business? These terms are often used interchangeably but are often defined differently. Most people define gross margin $ as revenue (or sales) less the direct cost of generating that revenue; and GM% is GM$ as a percent of revenue — which is the definition we use.

The questions are: a) What is GM% used for and why should one care about it? and b) What can happen if GM% is not used appropriately?

So what is GM% used for? The answer is: for a “for profit business” is to make a profit, which we will define as “net profit” (NP). If one does not make a profit, eventually they will go out of business. NP is equal to GM$ minus fixed cost. Therefore, at a steady fixed-cost level, the higher a company’s GM$ the greater its NP. In general, the higher one’s GM% the higher their NP will be, so one normally tries to increase their gross profit rate. This can be done by increasing prices or decreasing direct cost. Of course, if someone increases prices increase too much, it might also reduce demand unless they can demonstrate that the higher prices charged are clearly worth it to the client. The concern is, will clients overall agree to paying a higher price without losing volume, so that one does not generate any more GM$ then before? Likewise, if costs are lowered too too much, it might unfavorably impact quality and/or performance which could again lower volume. Therefore, a delicate balance of GM% is needed. Various markets and customers react differently, so it is important to know the dynamics of your market in regard to price sensitivity and GM%.

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The next question is, what will happen if GM% is used inappropriately? The answer lies in the trade off between GM% and volume to maximize NP. If GM% is increased and volume does not significantly reduce, then all is well. However, it is counterproductive if a higher GM% is more then offset by lower volume and reduces NP. The objective is to maximize NP not NM%.

Here is an example. Let’s start with a NM% of 20% and volume of $100, so NP$ is $20.

If NM% rises to 25% and volume is reduced to $90, the NP will be $22.50; the result is better than before. If the volume is down to $75 however, the NP would be $15 which more than offsets the NM% gain. Thus, if one is concerned about increasing NM% and does not focus on the more important impact on NP, they can make the wrong decision.

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