Gross profit margin is an important financial measure for business owners.
In fact I would say it’s equal with a handful of other metrics as THE most important financial metrics for business owners.
That’s because it is the first sign of the financial performance and health of a business, and if a business isn’t covering its cost of goods sold (even before all other expenses) then there are serious problems that need to be looked at. Even if a business is covering its COGS, if the gross profit margin lags the industry average then you are leaving money on the table. And no-one wants that.
However, gross profit margin can range between -100% and 99% and is heavily dependent on your industry, so what is a “good” gross profit margin?
In this post we’ll dive into this profitability metric by exploring:
- What is Gross Profit Margin?
- How do you Calculate Gross Profit Margin?
- Why is Gross Profit Margin Important?
- How do you use Gross Profit Margin?
- What are the Drivers of Gross Profit Margin?
- How Can Gross Profit Margin be Improved?
Let’s get right to it!
What is Gross Profit Margin?
Gross profit margin (sometimes referred to as gross margin) is a financial metric that indicates how efficient a business is at converting input costs into revenue. It is largely driven by your industry, but also measures your individual performance in managing your operations.
Said another way, gross profit margin shows the money your business has left over after paying off all direct expenses related to manufacturing a product or providing a service (the cost of goods sold).
Let’s use an example:
When your local pizza shop sells a pizza for $10, to calculate gross profit margin on that pizza we need to know what ingredients went into that individual pizza, and how much they cost. Let’s say that the dough, pizza sauce, cheese and toppings cost a total of $2, the cost of goods sold. Employee expenses, power and utilities, rent, taxes and everything else are not included. In this case the gross profit on that pizza is $8 and the gross profit margin is 80% (8 / 10 * 100%).
So gross profit margin indicates the performance of a business based on the efficiency of its production process. It’s profit left over after variable costs are paid, but before fixed costs and overheads.
How do you Calculate Gross Profit Margin?
As you could see in our pizza shop example, the calculation of gross profit margin is quite simple. Nothing to worry about here.
Repetition helps, so let’s do it here. To calculate gross profit margin, you subtract the cost of goods sold (COGS) from total revenue and then divide that number by total revenue.
You can start by calculating gross profit first, which shows the absolute profit after cost of goods sold (COGS):
Gross Profit = Total Revenue - Cost of Goods Sold
The formula to calculate gross profit margin as a percentage is:
Gross Profit Margin = (Total Revenue - Cost of Goods Sold) / Total Revenue x 100%
Gross Profit Margin = Gross Profit / Total Revenue x 100%
Nowadays, bookkeeping and accounting software and other business systems calculate gross profit margins for you automatically. But it is still important to understand how it is calculated so you can interpret the results.
Why is Gross Profit Margin Important?
Gross profit margin is a valuable financial metric to business owners, managers and operators because it indicates the ability of your business to convert revenue into profits. You can use this measure for your entire business or at an individual product level, for example:
- At the business level, take total costs away from total revenues for all products and services and divide it by total revenue. Understanding whether you are in a low margin or high margin business is vital to the decisions you will make for your business.
- At the product level, take the costs away from revenues for that product or service and divide it by the product or services revenue. Calculating gross profit margins for each of your products or services will tell you which are your profitable lines of business, and which are less profitable. You might want to focus on one product and less on another, or focus on trying to improve the margins of an underperforming business line.
Both really important uses for this metric that you can use to make decisions for your business.
How do you use Gross Profit Margin?
There are two ways to use gross profit margin to help understand and improve your business or individual products and services:
- By comparing your trends over time: This means looking at your gross profit margin over time (it can be weeks, months, quarters or years depending on your business and access to data). Is it improving or deteriorating over time? This will give you important insight on your businesses performance that you can use to make improvements or changes if need be. For example, improving margins are a good sign and you should look into what is driving that improvement, what you can do to sustain the improvement, and whether you can look for ways to continue the improvement. If margins are deteriorating, you might want to do a deep dive into the root causes and then develop a plan of action to make changes that improve gross profit margins.
- By comparing performance to your industry: This means comparing your gross margins to the industry standard so you can determine where your performance sits relative to the industry. Gross margins are largely determined by your industry structure (for example, General Motors does not eat 80% gross margins while Ford is earning 5%) and it is important to know the scope of your outperformance or underperformance. For example, if the industry wide gross margin is 20% and your margin is currently sitting at 10%, then this is a good sign that there are improvements to be made in your business and you should look into how to improve.
So there you have it, gross profit margin is simple to calculate and easy to use. Next let’s look at how you can improve your gross profit margin.
What are the Drivers of Gross Profit Margin?
Let’s reiterate the drivers of gross margin so we know how we can improve performance. By looking at the formula used for calculating the metric, we can see that there are two drivers of gross profit margin:
- Revenue, and
- Cost of Goods Sold.
So we have revenue and cost of goods sold to work with, to improve gross margins. Let’s look at some ways we can do this.
How can Gross Profit Margin be Improved?
Because revenue and cost of goods sold are the drivers, the two ways to improve gross profit margins are to (1) increase revenue while keeping the cost of goods sold the same, or (2) reduce the cost of goods sold across all sales.
To increase revenue while keeping the cost of goods sold the same you can:
- Increase prices: Taking a product or service with a price of $100 and COGS of $50, and increasing the price to $200 does nothing to the COGS (unless you change the product or service to justify the price increase). So all else equal, if you can increase prices without increasing COGS, in our example your can increase gross profit margins from 50% ((100 - 50) / 100 * 100%) to 75% ((200 - 50) / 200 * 100%). Beauty!
- Change sales mix: Some of your products or services will have higher margins than others. By encouraging customers to buy your higher margin products and services, it will lift your overall profitability. It’s surprising how many businesses have this opportunity, and it’s often overlooked.
To reduce the cost of goods sold across all sales you can:
- Reduce volume: If you can find ways to use less inputs, then you can reduce your COGS per unit sold. For example, if you typically use 250 grams in a burger, you can reduce this to 200 grams and save the cost on 50 grams of meat. For a service, if you can find ways to reduce the hours needed to deliver the service, say from 100 hours to 75 hours, the difference will increase gross margins. Both product and service improvements can be achieved by reducing usage or improving processes.
- Lower prices paid: You can reduce prices paid for your inputs, for example, by negotiating with suppliers for lower prices or discounts. This is a simple way to improve gross margins and probably the most common.
Gross profit is the first step towards profitability.
It measures the ability of your business to convert revenue into profit, before all other costs and overheads are considered.
If you don’t have a healthy gross margin for your industry, you’re simply going to earn less from your business. That’s why you should continually monitor your gross profit margins, compare it to your industry benchmark, continually look for ways to improve it, and sustain those improvements.
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