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.
Target Gross Margins in Manufacturing and Retail
An enterprise that is manufacturing a number of different products, may find that there is more room for raising the prices of some products than for others. In this case, the target gross margin may be computed as a result of varying strategies with different products. It may be possible to raise the price of certain well-established products with a well known brand name, and which command customer loyalty. However newer products that still need to increase their market share may require a different strategy; perhaps involving lower prices in the short term so as to carve out a higher market share. An enterprise that is organized into different divisions may look at the gross margin earned by each division, and take the variations into account when planning the target gross margin for the whole enterprise. Target gross margins in manufacturing indicate that, they may vary greatly according to the type of goods produced and the company strategy adopted.
Retail is an example of an industry where examples of target gross margins show that these are squeezed to an extent where there may not be much room for changes in the pricing policy. The target gross margin may be obtained, not so much by increasing prices, as by managing the cost of goods sold. In the case of large retailers especially, this would involve driving hard bargains with suppliers so as to reduce the price at which goods are bought in. It would also involve greater efficiency in inventory management so as to reduce warehousing costs and losses, through deterioration of products or obsolescence of slow-moving inventory items.
Target Gross Margin for Service Industries
By contrast, certain consultancy or financial services enterprises might have higher target gross margins. A consultancy might use a costing system in which the most important direct cost is the salaries of the consultancy staff. This time would be charged to clients at a high mark-up, resulting in a gross margin that might for example exceed 40% in some cases. The flexibility to adjust fees might be higher for consultancy type work where the consultancy might be providing unique services, while for other functions which are more routine in nature the margin would be lower. Software firms might be expected to have high gross margins where they are developing bespoke systems for clients whereas routine service functions might have little scope to increase target gross margins.
A services firm setting its target for gross margins must ask similar questions to those considered by a retail firm or manufacturing enterprise. The firm must consider if its existing gross margins are high enough, and look at the effect on its client base if fees are increased. Where the direct costs mainly consist of the salaries of consultants there is likely to be little room for reducing these costs without adversely affecting the capacity to provide high quality service to clients.
Variations in Target Gross Margin
Higher margins are not the only consideration for an enterprise aiming to boost its profitability. In the case of a retail operation such as a supermarket, a low gross margin can result in high profits if the turnover is high. A lower gross margin could be part of a policy for lowering prices and increasing turnover. Among other retail concerns, the level of target gross margin will also vary greatly. A retailer of fashion clothing will be concerned with targeting a higher gross margin, relying not just on the number of articles sold but on maintaining higher prices based on the reputation of the branded articles sold.
However for other types of business such as a niche consultancy the level of the gross margin will need to be higher to ensure profitability. The quality rather than the quantity of the work taken on will be an important consideration for a consultancy at the high end of the market. An example of target gross margin for a niche consultancy might be a “40/20” range where a gross margin of 40% covers overhead expenses and leaves a net margin of 20% after those expenses.
Examples of target gross margins therefore vary greatly from one industry to another, depending on the type of product or service sold, the cost structure, the uniqueness of the product and the price elasticity of demand for the product. All these considerations must be taken into account in setting a target gross margin for the products or services provided by an enterprise.