Computing Target Gross Margins
The gross margin can be defined as the difference between the sales revenue and the cost of goods sold, expressed as a percentage of sales revenue. This differs from the mark-up, which is the amount by which the cost of a product is increased to arrive at a sale price. For example, if a product that costs $200 is resold at $300, the mark-up is $100 or 50% ($100 divided by $200). However the gross margin on the sale, which is $100, is expressed as a percentage of the sales revenue, and is therefore $100 divided by $300 or 33.3%. Examples of target gross margins will show that these will differ from industry to industry and enterprise to enterprise.
The target gross margin has to be high enough to cover the overhead expenses of the business and still earn a net profit for the business. The enterprise must therefore plan a target gross margin, that takes into account the need to cover those overhead expenses, and provides sufficient net profit to enable the business to meet other necessary payments, such as interest on loans, taxation and dividends to shareholders.
The target gross margin will depend on factors, such as the amount of competition in the industry and the cost structure. When planning a target gross margin, the enterprise must look at the level of prices it will set, and the level of direct costs. An obvious way to increase the gross margin is to raise the price of a product. However depending on the price elasticity of demand for the product, and the pricing strategy of competitors in the same industry, combined with the general economic climate, there may not be much room for adjusting prices upwards.