A Guide to Proper Gross Margin Calculation for Digital Manufacturing Startups
Praxis is a lead pre-seed investor in manufacturing and software startups. This post shares best practices on gross margin calculation from Will Langton, the retired EVP Finance and CFO of Protolabs.
Digital Manufacturing Founders: Greetings from Minnesota!
My name is Will Langton and I’m the retired EVP Finance / CFO of Protolabs.
I joined Protolabs in 2006 as its first CFO, when the business was known as the “Protomold Company” with $17 million in revenue and proudly served through its 2012 IPO, $350 million in revenue, $100 million in EBITDA, and a multi-$B market cap.
I retired from Protolabs in 2017, but maintain a consulting practice which includes advising digital manufacturing startups in the portfolio of Praxis Ventures on best practices for a startup’s financial statements and financial analysis.
Below, I’ll share a guide with best practices for founders in digital manufacturing to consider when calculating gross margins to share with boards and investors.
Gross Margin (also known as Gross Profit) is more than just a number you include in a pitch deck to VCs. It is a window into the true financial health of a company, the honest value of your software and technology in process improvement, and the long-term earnings potential of a digital manufacturing startup.
Gross margin measures actual production and business efficiencies from your software and technology stack.
Careful analysis of gross margins, over time, will help identify the ideal pricing, product cost strategy, and most importantly, the early prioritization of process R&D and software development to ensure long-term high profits and a healthy financial future.
Gross margin is also expressed as a percentage, which is often used when comparing financial periods. Companies desire, and wise investors pursue, high gross margins, as it means a company is retaining more capital from every dollar of sales.
Wise investors study gross margin percentages to compare the profitability and profitability potential of different companies. High margins make it easier for companies to source additional growth funding from customers, due to the retention of more of each sales dollar. Gross margin greatly influences the long-term value of a business. Resist the temptation as a venture-backed startup to aggressively invest to ramp early revenue, if your gross margins are weak.
Gross margin is the result of subtracting the cost of goods sold (COGS) from net sales. When people think of COGS, they typically think of raw materials or parts and the labor required to create the product. However, COGS contains more elements that should be considered. COGS is typically broken down into three large components with more detail under each component.
Direct labor, Direct Materials, and Direct Overhead
1. Direct Labor. Labor to produce, assemble, and ship a product. This includes factory management, engineers helping in the factory, and personnel running the equipment or assembling a product. Often in startups, mechanical or software engineers will work in a factory and in R&D. In this case, their costs should be allocated accurately between the two areas.
2. Materials. This includes raw materials such as resin, metals, and parts to be assembled. Freight costs to get materials to the factory should be included here.
3. Direct Overhead (to be honest, it includes some indirect items as well). Direct Overhead is the item that is most often overlooked in startups and smaller companies. It is harder to measure with expenses being comingled with R&D or expenses needing to be allocated, such as utilities and facilities costs. Understanding this component of COGS, though, is important information to running and investing wisely to scale your business. In a manufacturing company, it includes the cost to operate the machinery to make the items such as the supplies, utilities, maintenance, and other equipment costs. Some examples are listed below:
Production supplies. This includes items that are not specific to a product, end mills are one example, protective equipment for workers, supplies consumed in manufacturing, packaging, shipping, or storing a product. This also includes the cost of small tools that are used for brief periods of time in the production process. Depending on the number of items this can be broken down into sub-categories, such as manufacturing supplies, safety supplies, packaging supplies, and other supplies.
Equipment Rental. An item that is frequently overlooked by startups.
Repairs and Maintenance. Each business will have varying amounts in this category, nonetheless it should be included for completeness.
Fixed Asset – Depreciation. Assets used in the production, assembly, and distribution of a product. This can include equipment depreciation, software amortization, and an allocation of building depreciation if the building is owned.
Facilities Rent. the portion of a facility rent that applies to manufacturing and distribution.
Utilities. Electricity, gas, water, trash collection, etc. Often, a manufacturing startup may not have a separate utility meter for the production portion of their building. If not, they should calculate the percentage of utilities used by that portion of the building as compared to the rest of the building, divide each utility bill by that percentage, and apply it to direct overhead.
Shipping. This is typically the cost to ship products to the customer. Inbound shipping costs for raw materials and supplies typically follow the item purchased to the correct account.
IT costs related to running a factory. This can be a difficult item to measure, it may be de minimis to COGS and a judgement call will need to be made to determine if it is worth measuring. Things to include can be subscription costs for software used to manage the factory or inventory.
By following these steps to calculate COGS, you will arrive at a comprehensive and intellectually honest calculation. Using this approach to determine Gross margin will provide you a Gross margin that accurately reflects the operations and health of your business, and the strength of your underlying technology and software in driving efficiencies within your chosen process or processes. This will give investors and users of your financial statements confidence in the information provided.