If you own a business, monitoring your profit margins regularly will give you the valuable data you need to identify the most lucrative areas of your business and scale them.
"Understanding your profit margins is particularly essential in navigating volatile times," says Claude Compton, founder of Pave Projects, a hospitality group. "Having a deep understanding of your profit margins allows you to be adaptable and pivot at speed, while providing proactive leadership and fact-based decision making."
Here's a look athow to calculate gross profit margin.
How to Calculate Gross Profit
The gross profit margin calculation measures the money left from the sale of your goods or services, once the operating expenses used to generate them are deducted (e.g. labor and material costs). Gross profit is calculated by subtracting the cost of goods sold (COGS) from the total revenues. Let’s look at each of these in more detail.
Cost of Goods Sold (COGS)
The cost of goods sold refers to all the direct costs and expenses involved in producing or delivering your goods and services. It does not include indirect costs, such as staff salaries or sales and marketing. Below are some examples of COGS:
- Raw materials or parts needed in manufacturing
- Direct labor costs associated to production
- Shipping costs
- Time spent assisting a client
- Equipment costs involved in production
- Utilities for the production facility
Revenue
It is the total amount of income yourcompany generates from the sale of your products or services. It shows you clearly how much money you’re bringing in from your total sales. It does not include thecosts of running your business, such as taxes, interest, and depreciation.
What is the gross profit formula?
The gross profit formula is:Gross Profit = Revenue – Cost of Goods Sold.
What is the gross profit margin formula?
The gross profit margin formula,Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue x 100, shows the percentage ratio of revenue you keep for each sale after all costs are deducted. It is used to indicate how successful a company is in generating revenue, whilst keeping the expenses low.
Gross Profit Margin Formula Example
As an example of gross margin, a shoe-maker might sell a pair of shoes for $50. They cost $15 to make, yielding the retailer a gross profit of $35. This equates to a margin of 70%.
- Total product revenue: $50
- Total production costs: $15
- Gross profit: 50-15 = $35
- Gross profit margin: 35/50 x 100 = 70
Let’s take a service-based business. Imagine the company is an accounting firm that audits other businesses. A single audit sells for $500 and costs $100 to produce, yielding a gross profit of $400. This is a margin of 80%.
- Total product revenue: $500
- Total production costs: $100
- Gross profit: 500-100 = $400
- Gross profit margin: 400/500 x 100 = 80
Why the Gross Profit Calculation Is Important
The gross profit margin varies across products and sectors, and is often used to measure the profitability of a single product. It indicates how efficiently you are using your resources to produce your goods or deliver your services.
Understanding your profit margins is particularly essential in navigating volatile times.
—Claude Compton, founder, Pave Projects
“If a business has a number of projects, or a number of products, then reporting on each separately is a great way to ensure that each component of the gross profit margin is performing as it should be,” says Compton. “Often, a lower result is due to one or two projects or products not being as profitable as expected.”
A strong understanding of your margins in business allows you to make quick decisions to support the growth and resilience of your company. For example, a spike might indicate a new trend that warrants additional investment, whereas a decline might highlight rising expenses, prompting you to analyze your cash flow and make cuts where necessary.
“We look at gross profit margins and specific key performance indicators in real time daily and review in more detail on a weekly basis,” says Compton. “This regularity allows the business to ride out changing tides and isolate any issues before they become a long-term problem.”
As an example, by analyzing your margins, a business will be able to pin down related price increases due to unexpected economic disruptions.
Marketing Costs and the Gross Profit Formula
The gross profit margin formula only includes the variable costs directly tied to the production of your goods or services. Wider company expenses, such as paying for the corporate office, are not included in the final metric. Instead, these expenses sometimes show on an income statement as ‘Selling, General, and Administrative’ costs. These can include the wages of employees such as accounting, IT, and marketing as well as advertising and promotional materials. It also includes any rent, utilities, or office supplies that are not directly used to create a specific product. This means marketing costs are generally not included in the gross profit formula.
However, just because marketing and other indirect costs aren’t factored into the gross profit calculation doesn’t mean you shouldn’t keep a close eye on them too. These ‘costs of doing business’ affect your cash flow just as much as expenses that are directly related to products and services.
One way to cut down on the time it takes to track these indirect costs is to set up real-time expense reporting so you know what’s being spent company-wide, as well as card payment reminders so you know what needs paying and when.Business tracker appscan help with this.
What is a good gross profit margin?
A high gross profit margin generally indicates you’re making money on a product, whereas a low margin means your sale price is not much higher than the cost. But it’s important to remember that while these figures are a useful reference, margins vary widely by industry and company size.
Knowing how to calculate your gross profit margins helps you to better manage your cash flow, ensuring there's always enough money to pay your suppliers and expenses on time.
Photo: Getty Images
