Accounting
What Is Gross Profit Margin and How To Calculate It
Small business owners are generally so busy running their businesses that they don’t have time to worry about each and every number in their financial statements or every possible financial ratio. But one metric they should pay attention to is the gross profit margin. This number provides a quick way to assess the health of their business. So let’s dive into what this metric is and what it means.
WHAT IS GROSS PROFIT MARGIN?
Gross profit margin is a ratio that shows how much of each dollar of sales revenue is left after covering the direct costs associated with that sale. It’s a measure of a company’s efficiency in providing the goods or services it sells. Gross profit margin shows how much of each dollar of sales is left to pay operating expenses, R&D for new products, and reinvest back into the business.
Gross profit margin is often confused with other metrics: gross income, operating profit margin, and net profit margin. Gross income is the dollar amount of revenue remaining after subtracting cost of sales from the company’s revenue from all sources. Operating profit margin shows how much of each dollar of sales is left after all cost of sales and operating costs have been paid. Operating costs, also known as indirect costs, include marketing, R&D, general and administrative expenses, depreciation, and amortization, but not interest or taxes. Net profit margin shows the amount of money left after all business expenses, including interest and taxes, have been paid to arrive at net income. It’s a measure of a business’s actual bottom line.
What Is the Formula & How to Calculate Gross Profit Margin
Overall, the gross profit margin formula is as follows:
Gross Profit Margin = (Revenue – COGS) ÷ Revenue x 100%
Gross profit margin percentage calculation can be easily performed in two steps. First, subtract the cost Gross profit margin percentage calculation can be easily performed in two steps. First, start with the gross profit calculation and subtract the cost of goods sold from the company’s revenue to derive gross profit. Cost of goods sold, or COGS, is the accumulation of all the direct costs required to produce, purchase, or provide the goods or services sold. For a manufacturer, production costs include raw materials costs, direct labor costs, and allocated overhead costs. For service providers, COGS consists chiefly of the direct labor costs associated with providing the company’s services. The gross profit formula is:
Gross Profit = Revenue – COGS
Next, divide gross profit by revenue, and multiply by 100% to express gross profit margin as a percentage.
Gross Profit Margin = Gross Profit ÷ Revenue x 100%
Another way to calculate gross profit margin is directly from financial statements. Since gross profit appears as a line item on the income statement, the cost of goods sold is deducted from net sales.
Dividing income statement items like gross profit by revenue and expressing the ratio as a percentage is how common-size financials are created. These allow for comparisons between businesses of different sizes and across time for the same company.
Example of Gross Profit Margin Usage
Let’s walk through a couple of examples to see how this works. Depending on the industry, gross profit margin can vary quite a bit. Total revenue for Main Street Brewing for the latest year is $3 million. The cost of goods sold — which includes the raw materials and direct labor used to make their beers — is $2.8 million. Using our formula, gross profit is $3 million – $2.8 million = $200,000. Dividing the result by revenue, the gross profit margin is 6.67% ($200,000 ÷ $3 million).
Here’s an example of a business with a very different gross profit margin. The Corner Store is a small local grocery store with revenue of $45 million for the last fiscal year. Like many in the grocery industry, The Corner Store operates with low margins. COGS for last year was $44.3 million, resulting in gross profit of just $700,000 ($45 million – $44.3 million) and a gross profit margin of just 1.56% ($700,000 ÷ $45 million).
What Does the Gross Profit Margin Tell You?
Gross profit margin is a measure of a company’s financial health. Companies with healthy gross profit margins generally have fewer cash flow problems. At the very least, their total sales are sufficient to cover direct costs and likely enough to cover all variable costs and fixed costs. A high gross profit margin shows that a company has figured out how to profitably produce or provide its goods or services.
Over time, a company’s gross profit margin can offer insights into whether a company’s business operations are successful or struggling. Fluctuating gross profit margins can be a sign of instability and may spell trouble in the long run. Steady increases in gross profit margin can be a sign of healthy demand for a company’s products or that a company is continuously optimizing its processes to provide its goods or services at a lower cost. Decreases in this metric may signal that competition is eroding a company’s ability to increase selling prices to keep up with inflation or that direct costs are rising faster than total sales revenue.
What Is a “Good” Gross Profit Margin? Should It Be High or Low?
In general, a good gross profit margin will be between 5% and 10%. However, as noted above, good gross profit margins can vary widely, depending on the industry and the overall economy. For example, this table for public companies shows that at the high end, depository institutions (aka banks) had an average gross profit margin of 90.1% in 2020, down from 97.4% the year before. On the low end, miscellaneous repair businesses had a terrible year in 2020, with an average gross profit margin of -112.9%, a massive drop from 22.55% in 2019. These changes in gross profit margin are most likely related to the COVID-19 pandemic.
The best way to determine whether a company is on track is to compare its gross profit margin to other companies in the same industry and, if possible, to companies that are about the same size. Comparable data for small and medium-sized companies are available (for a fee) from RMA. Trade organizations frequently compile data for their industries.
Advantages and Disadvantages of Using Gross Profit Margin
Because it can be easily calculated straight off a company’s financial statements, the gross profit margin is a handy financial metric for benchmarking. It allows comparison between companies of different sizes and in various industries. Gross profit margin can also be used to assess a company’s financial health quickly. Gross profit margin can be used within a company to evaluate profitability by product line or location and identify areas for improvement. It can be used to assess the viability of a product line. Problems with pricing can be quickly revealed if the gross profit margin for a product line is low or even harmful.
However, like all financial metrics, the gross profit margin has some disadvantages. Because it doesn’t include operating expenses, it doesn’t indicate whether a company is profitable overall. A company may have a high gross profit margin, but if total sales volume decreases, this may not be sufficient to cover operating expenses. COGS can vary substantially depending on the inventory valuation method and the costing methodology used, so the gross profit margin may be a flawed measurement. Also, as noted above, gross profit margins can vary widely across different industries and by company size.
Gross profit margin should be one of several financial ratios monitored regularly by small businesses. Understanding how the numbers in your financials come together and their relationships can make the difference between success and failure.
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