Gross margin is one of the most underestimated financial metrics among small businesses. Despite its simple calculation, your gross margin can actually make or break your startup. Because gross margin represents a business's revenue after accounting only for the cost of producing goods or services for sale, a low margin often means your business won't have enough income left over to cover fixed expenses or the other costs of running the business, such as interest payments on debt and taxes.

Without a firm understanding of how to determine the gross margin and what factors influence it, you could have a great product and firm client base and still be losing money. Understand the components of the gross margin, observe how a weak figure can spell disaster for a budding company and see how to use gross margin analysis to strengthen your business model.

What Is Gross Margin?

Gross margin is simply a business's revenue minus the costs directly associated with creating its products. Direct costs are typically variable costs, meaning the amount of the expenditure is directly related to the number of items produced. These include raw materials, supplies and wages for labor required to manufacture, build or assemble products.

Expenses such as administrative costs, rent and the salaries of management employees are not included in the calculation of gross margin because they do not depend on the scale of production. Because a wide variety of very necessary expenses are not included in the calculation of gross margin, most companies need to have fairly high margins to ensure there is enough revenue left over to cover all of the other costs of doing business.

Example

Assume a business produces shoes and sells 1,000 pairs each year at a retail price of $50 per pair. If it costs $15 to manufacture each pair of shoes, including the cost of materials and wages paid to workers, then the total direct costs incurred for all 1,000 pairs is $15,000. The gross margin is calculated by subtracting $15,000 from the total revenue of $50,000. As a dollar amount, called gross profit, the gross margin is $35,000. As a percentage, which is the more common format, the gross margin is $35,000 / $50,000, or 70%.

Impact of a Low Gross Margin

A low gross margin can spell disaster for a company of any size, but it can be especially detrimental to a startup. New businesses often incur much larger expenses relative to their revenues than more established companies.

For example, a startup may have to pay upfront for equipment, facilities and supplies. Though these things are necessary to build a business, they do not provide profit immediately. If a business requires a sales staff or factory workers, it must pay wages before its products are even on the shelves. In addition, many new businesses have substantial debt from loans used to get their operations off the ground. A low gross margin can seriously undermine a business's ability to meet its debt obligations each month.

Businesses that operate online and do not have physical storefronts may have an easier time operating with low gross margins, since many of the expenses incurred by brick-and-mortar establishments are eliminated. Nevertheless, a low gross margin can make it difficult for a company to generate enough profit to fund growth projects or develop new products. In short, a mediocre margin can seriously stunt a business's potential in the long term, even if it does manage to stay afloat in its early days.

What Causes a Low Gross Margin?

A company may have a low gross margin because its prices are too low, its costs are too high or a combination of the two. Though this seems fairly obvious, it is very common for new business owners to fail to understand how or why their startups are bleeding money. In many cases, entrepreneurs are afraid to make prices too high, fearing that consumers may choose a cheaper competitor instead. On the other side of the coin, shoddy workmanship or low-quality products can also cause a business to lose its share of the market. Finding the right balance of quality and cost, therefore, is essential to maximizing gross margin.

Economies of Scale

Often, producing a greater number of items results in a lower cost per item, though at a larger overall expense. This is due to the economies of scale and it is another reason why startups may struggle to maintain healthy gross margins. When a business buys supplies or raw materials in bulk, the wholesale discount of those purchases lowers the cost of producing a single item. To benefit from this discount, however, companies must typically make very large purchases.

Small businesses or new startups often don't have the capital on hand to invest in such large-scale production, especially if the marketability of the product is untested. This means that a newer business is likely to have a lower gross margin than a larger company that sells an identical product. Because the big guys can buy and manufacture in bulk, their per-item costs are lower. This is why it is difficult for new businesses to break into industries that are already dominated by large competitors.

Benefits of a Healthy Gross Margin

A startup with a healthy gross margin generates enough revenue to cover the costs of production, as well as fixed costs such as administrative expenses, rent and utilities, interest payments on debt, payroll, taxes, insurance and advertising costs. This makes it much more likely that the business will succeed, and it opens the door to many growth opportunities that would not otherwise be available.

Banks, for example, look at the financial statements of businesses applying for loans. A healthy cash flow and low expenses mean that a business is more likely to be able to pay off a loan on time. A startup with a solid gross margin is more likely to be approved for additional financing, which it can then use to accelerate expansion.

Conclusion

If you're considering starting your own business or are trying to figure out why your current business is floundering, remember to analyze your gross margin. Before getting bogged down in the intricacies of corporate finance, start with the simple stuff: revenue and costs. Keeping your direct costs down is a great start, but be sure you're also charging a reasonable price for the product you offer. While an inflated price tag may turn customers away, a price that's too low may signal to consumers that your product isn't very good and can end up costing you more than just sales.

Of course, what constitutes a healthy or unhealthy gross margin varies by industry. When analyzing your startup's finances, be sure to compare them to those of a successful business of a similar size within the same market to ensure an accurate analysis.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.