How to Calculate Gross Profit Margin
The gross profit margin is a vital metric that most businesses use to track the health of their business. It offers insight into the business’s performance and gives a view into its future success. Keeping an eye on the gross profit margin is very important for most businesses to stay healthy and viable for the long term.
In this blog, we discuss the gross profit margin and how to calculate it.
What is a profit margin?
Before we explain what gross profit margin is, we need to understand what a profit margin is generally.
In general, a profit margin is a gap between how much it costs to bring a product or service to market and what it costs.
Let’s say that you grow apples and want to sell them. A lot of costs are involved in growing your apples, from the cost of land, fertilizer, the labour involved in picking the apples, the logistics in transporting the apples from one place to another, and more.
In general, let’s suppose that it costs you $0.10 to get every apple from a tree into a supermarket. If the supermarket buys each apple for $0.30, your profit margin is $0.20.
You can have a profit margin for individual items, but also for businesses as a whole. You can apply the same basic formula.
When talking about businesses as a whole, profit margin represents what percentage of sales has turned into profits. For instance, if a business reports a 30% profit margin during its last quarter, it means that it had a net income of $0.30 for every pound of sales generated.
What is a gross profit margin?
The gross profit margin is different from the simple profit margin. The gross profit margin shows the percentage of sales revenue a company keeps after it covers all direct costs associated with creating the good in question. It is only one of several calculations that businesses can use to gain insight into their performance.
If a company has a high gross profit margin, it means it has more cash to pay for indirect and other costs. A lower gross profit margin might mean that a company has less cash to spend on these things.
Gross profit margin vs net profit margin
The gross profit margin is often confused with the net profit margin. The net profit margin measures how income is generated as a percentage of revenue. It is the ratio of net profits to revenues for a company. The net profit margin illustrates how much of each dollar in revenue collected by a company translates into a profit.
The net profit margin must factor in all business activities, including:
- Total revenue
- All outgoing cash flow
- Additional income streams
- Investment income
- One-time payments
Gross profit is the gross profit divided by the total revenue and is the percentage of income retained as profit after accounting for the cost of goods sold (COGS). These include things like raw materials and expenses associated with the creation of the product. It does not usually include the costs of running a business, such as rent, overhead, utilities, and other factors.
Net profit, on the other hand, takes all expenses into account, including overhead, costs, and cash flow issues.
Net profit and gross profit are often instructive to compare, as they may reveal where in the business improvements need to be made. If your gross profit is high but your net profit is low, there may be some issues you need to resolve in your overhead costs.
Gross profit margin vs operating profit margin
The operating profit margin is often derived from the gross profit margin. Operating profit takes the gross income of a company and subtracts all overhead, administrative, and operational expenses, including rent, utilities and payroll.
An operating profit margin is generated by taking operating expenses and dividing them by total sales, like this:
Operating profit margin = operating costs / revenue.
Just like with net profit, comparing gross profit and operating profit can be instructive. While a company may have a great gross profit, if their operating profit is low, it may indicate a problem with the company’s operating expenses.
How to calculate your gross profit margin
You can calculate your business’s gross profit margin by using this formula:
Gross profit margin = (net sales - COGS) / net sales
You can get your company's gross profit margin by subtracting the cost of goods sold (COGS) from the net sales (gross revenues minus returns, allowances, and discounts). Then divide by net sales. This will give you your gross profit margin in a percentage.
What you can learn from the gross profit margin?
The gross profit margin can be very helpful for businesses to find out how well their company is performing.
The gross profit margin is especially useful when tracked over time. A gross profit margin that increases or decreases over time might indicate market forces that the company has to pay attention to. It might also indicate the efficacy of your pricing strategy.
For instance, if you implement a prestige pricing strategy, but your net profits remain static or go down, that may indicate that your pricing is off, and you may want to consider approaching your product marketing differently.
Or, your company may decide to automate certain processes. The initial investment in automation may be high, but the savings should appear over time as the cost of producing the product inevitably goes down.
Gross profit margins may be high one day but decrease the next. Airlines are a good example of this. Many airlines inflate their prices when they expect the price of fuel to go up, giving them a short window of improved profits before the inevitable hit.
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