# Improvement tools: Gross margin analysis

Page last updated: Tuesday, 11 July 2017 - 11:53am

Please note: This content may be out of date and is currently under review.

Gross margin analysis provides a guide to the relative profitability of different improvement options. It helps to decide whether a potential improvement is worth implementing, or whether one option is better than another option.

The gross margin of an option is the gross income produced from the option less the variable costs from implementing it. It does not take into account fixed or overhead costs such as depreciation, interest or permanent labour.

A gross margin is usually expressed as dollars per unit of the most limiting resource, for example, dollars per hectare, dollars per megalitre of water or dollars per employee.

To calculate a gross margin you need three things:

1. The quantity of outputs you expect the option to produce. For example, tonnes of grain or kilograms of beef.
2. The price you expect to receive.
3. The variable costs of implementing the option. These are costs that change depending on the size of the operation. For example, if the area of wheat grown doubles, we would expect the cost of seed to roughly double.

How to work out a gross margin

1. Multiply the quantity you expect to produce by the expected price. This will give you the gross income.
2. Work out the total of the variable costs.
3. Subtract the variable costs from the gross income.

 Gross income = quantity produced x price Gross margin = gross income - variable costs

For gross margin analysis in a livestock enterprise, gross income will take into account the value of any changes in livestock numbers.

To work out whether an improvement option is worth implementing, calculate the gross margin for the current operations. Next, calculate the gross margin for the improvement option. Then compare the two gross margins.

If you are comparing several improvement options, calculate gross margins for each of the options as well as the current operations. Then compare the gross margins.

Although it can be difficult to predict prices, yields and costs, it is still better to evaluate your options based on available information and your own estimates.

Gross margin analysis is best used for comparing options that will make use of the same type of resources. For options that require additional capital investment, partial budgets are a quick method to use in place of gross margin analysis.

In the 'Documents' section on the far right are examples of gross margin calculations for a grain enterprise and dairy enterprise. These are examples only; they are not based on actual businesses. Prices and costs are not current.

Other tools to use with Gross margin analysis

Gross margin analysis can be used in steps 3 and 6 of the CI&I - Continuous improvement and innovation process.

The Eight criteria technique can be used in combination with gross margin analysis. The Eight criteria technique uses other criteria, in addition to the financial information provided by the gross margin analysis, to compare improvement options.

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