How to Calculate Gross Profit, Increase it, and Be Loved by Customers

| October 10, 2011 | By

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.

  1. Add up all of the costs you incurred to make your product or service. These are the variable costs like materials, direct labor, etc.
  2. Subtract the costs calculated in step one from the price of your product or service. The resulting figure is your gross profit.
  3. Divide your gross profit (calculated in step 2) by the price tag of your product or service and you have your profit margin.
An example is in order. For sake of easy figures, lets say you sell your widget for $1,000 and the cost of the materials, labor, and other direct costs add up to $330. Your gross profit is $1,000 - $330 = $670. That means that your gross margin is $670 / $1000 = 67%
Sooooooo.....for every dollar of product that you sell, you spend 33 cents on the costs to make it and you get to keep 67 cents to help pay for the overhead of the business. Easy!

How to Increase Your Gross Margin

Alright, lets get back to LEGO man above. In business, there are two kinds of companies that win.

  1. Those that focus on product differentiation (Having the best product or service on the market)
  2. Those that focus on being the low cost leader (Having the cheapest product or service on the market)
Both strategies are great, but here is the kicker - you can't do both at the same time. If you decide to be the low cost leader, your profit margins will erode and you'll have to win on volume which is very difficult. If you decide to focus on product differentiation, you have a lot of options and the best part is that you get to "Wow" your customers.
As an Ignite Spot client, I would ask you to consider what strategy fits you best. Either one is fine. If you feel that you want to focus on product differentiation in your industry, let the party begin. Here's the main question, "How can you take your product or service and kick it up 10 notches?" I'm not talking about making a small improvement. I'm talking about radically excelling in your industry.
How can you take your product or service from being average (like the LEGO guys I built as a kid) to extraordinary (like the LEGO guy my son built this morning)?
Finding new and creative ways to make a product or provide a service gives you the opportunity to charge more. If you want to increase your profit margins, don't simply raise the a better LEGO guy that your customers will be willing to pay more for

How to Be Loved by Your Customers

When you do that, you'll be able to double your profit margin and here is the best part... your customers will love you for it. Now you provide a high quality product or service that they love. You provide a product or service that fits into their life and gives them everything they need.
The first step to running a successful small business is in learning how to calculate profit margin. The second step is in learning how to use that percentage to lead the industry.