Gross Profit Margin: How to Calculate ItReading Time: 4 minutes
One way to measure the profitabiıliy of your business is to calculate the gross profit margin.
To provide services or goods to consumers, small businesses need to make some compulsory expenses.
These expenses include software subscription fees, raw materials, labor, or equipment. You’ll need to keep tabs on them to measure profitability.
In this article, we’ll discuss the following:
- What is gross profit margin?
- Formula and How to calculate it
- What does gross profit margin tell you?
- How to improve the gross margin
- What are its limitations?
What is gross profit margin?
Having significant revenue is only good enough if you have an idea of your gross margin.
The gross margin clearly shows how much is spent on making your goods or services available.
You can obtain the gross margin by subtracting the net sales/total revenue from COGS and dividing the resulting value by total revenue.
To express the margin in percentage, the resulting value is multiplied by 100.
See also: How to calculate Net Profit Margin
Let’s look at the…
Gross profit margin formula
Below is how to calculate the gross margin:
Gross profit margin
(Gross Profit ÷ Total Revenue) x 100
- Gross Profit = Total Revenue – Direct Expenses (Cost of goods sold)
- Revenue = the total amount of money earned from goods or services
- COGS = This includes direct labor and raw materials
How to calculate gross profit margin
Let’s say the Lazy Company has a revenue of $1,000,000 and spends $600,000 on direct expenses – the cost of goods sold (COGS).
Gross Profit Margin = (Gross Profit / Revenue) x 100
Calculate the gross profit, which is:
Gross Profit = Revenue – COGS = $1,000,000 – $600,000 = $400,000
Gross Profit Margin = ($400,000 / $1,000,000) x 100 = 40%
The Lazy Company’s gross profit margin is 40%.
This means that the Lazy Company keeps 40 cents as profit for every dollar of revenue after accounting for the cost of goods sold.
What does gross profit margin tell you?
It measures your company’s efficiency in controlling the costs associated with producing and selling products or services.
A higher margin indicates that your company can generate more revenue while keeping costs low. While a lower margin suggests that your business could be more efficient in controlling costs.
It’s also important to note that the gross profit margin measures profitability and efficiency but needs to give the complete picture of financial health.
It doesn’t consider other expenses, such as operating expenses, taxes, and interest.
Check out: What are expense accounts in accounting?
It’s essential to look at other financial metrics such as net profit margin, return on assets, return on equity, and cash flow to get a better understanding of your company’s overall financial performance.
How to improve the gross profit margin
There are several ways to improve gross margin, which include;
- Increasing prices: A company can increase its gross margin by increasing the prices of products or services. However, be cautious when implementing this approach, as it could lead to a decrease in demand.
- Reducing costs: One of the most effective ways to improve gross margin is to reduce costs associated with producing and selling products or services. This could include negotiating better deals with suppliers, streamlining production processes, or implementing cost-saving measures such as automation or outsourcing.
- Product or service differentiation: You could differentiate from competitors by offering unique or high-value products or services and charging premium prices.
- Diversifying revenue streams: By diversifying the types of products or services offered, you can reduce the reliance on one product or service and increase the chances of success.
- Managing inventory efficiently: By keeping inventory levels low, you can reduce the costs associated with storing and managing inventory.
What are its limitations?
While the gross margin is a valuable metric for evaluating a company’s efficiency in controlling costs, it has some limitations:
- It only looks at the relationship between revenue and cost of goods sold and doesn’t consider other expenses such as operating expenses, taxes, and interest. This means that if your company has a high gross profit margin, it may still need to be more profitable due to high overhead costs.
- It gives a snapshot of a company’s profitability but needs to tell the full financial health story. It’s essential to look at other financial metrics such as net profit margin, return on assets, equity, and cash flow to understand the overall financial performance better.
- Different industries have different cost structures and margins, so comparing companies’ gross profit margins within the same sector is essential.
- Companies can be profitable and still need help generating cash if they have high debt levels or have to invest heavily in future growth.
- The level of competition in an industry can also affect the gross profit margin, as companies in highly competitive industries may have to lower their prices to remain competitive.
The gross profit margin is a valuable metric for evaluating your company’s efficiency in controlling costs and profitability.
However, it would be best if you considered its value in conjunction with other financial metrics to give a comprehensive picture of your company’s financial health.
Also, improving gross margin will positively affect your company’s overall profitability. Still, weighing the trade-offs between increasing prices or reducing costs is essential, as it might negatively affect customer satisfaction or sales.
Frequently Asked Questions
What is a good gross profit margin ratio?
- A ratio of 50 to 70% would be considered healthy in businesses like retail, restaurants, manufacturers, and other producers of goods. According to CFOHub, it varies across industries.
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Gross profit vs gross margin
- Gross profit is the amount of money a company makes from its total revenue after subtracting the cost of goods sold (COGS). In contrast, Gross margin is a percentage that represents the proportion of revenue that exceeds the cost of goods sold. It is calculated by dividing gross profit by revenue and multiplying by 100. Gross profit is the dollar amount, and gross margin is the percentage of revenue that is profit.
What’s the difference between gross profit and net profit?
- Gross profit is the amount of money a company makes from its total revenue after subtracting the cost of goods sold (COGS). It is calculated by subtracting COGS from revenue. Net profit, also known as net income, is the amount of money a company has left over after all of its expenses have been paid. Check out the difference between gross profit and net profit.