Gross profit margin is a metric that can be used to measure business performance and efficiency. Gross profit margin, sometimes referred to as gross profit or gross margin, lets you measure revenue against cost of goods sold, which gives you a good idea of how profitable your business operations are.
Overview: What is gross profit margin?
One of the most important small business accounting tasks any small business owner should be doing is using various calculations that provide insight into how your business is performing financially.
One of the best (and easiest) calculations is gross profit margin. Gross profit margin effectively measures the overall financial health and efficiency of your business, determining the amount of profit left over after direct production costs have been subtracted.
To calculate your gross profit margin, you’ll need to calculate your revenue total and your cost of goods sold for the accounting period. In order to get a more accurate picture of your business efficiency over time, you should calculate your gross profit margin regularly.
An important metric for business owners, gross profit margin is also a key metric for investors, potential investors, and financial institutions as it provides financial details about a company’s core business operations.
For example, a higher gross profit margin indicates that your business is financially sound and able to produce products and services efficiently and profitably.
On the other hand, a low or negative gross profit margin may point to a lot of issues, including inflated production costs, pricing that’s too low, or generally faulty operations that are preventing your business from earning a profit on the goods or services you’re selling.
Gross profit margin vs. net profit margin: What's the difference?
Gross profit margin: All business owners want to know if the product or service they’re selling is actually profitable. The best way to determine that is by calculating gross profit margin, which is the difference between sales revenue and your cost of goods sold.
Calculating gross profit margin provides a clear picture of operational efficiency and core profitability, with the results also indicating how much profit is left over that can be used to cover other business expenses such as overhead or selling costs.
Net profit margin: More comprehensive than gross profit margin, net profit margin, or net margin, is the percentage of income that’s generated from your business revenue after all expenses have been accounted for.
While gross profit margin is designed to measure the effectiveness of your core business operations, net profit margin, or net margin, measures the overall profitability of your business, taking all operational, overhead, and administrative expenses into account, including interest and taxes.
While gross profit margin measures the efficiency of a business in terms of producing and selling its products and services profitably, net profit margin provides a more realistic view of the overall profitability of the business.
The gross profit margin formula
Determining gross profit margin is a simple calculation with the option to calculate margin using a dollar amount or a percentage. To measure gross profit margin as a number, the formula is:
Revenue - Cost of Goods Sold = Gross Profit Margin
However, most businesses find it more helpful to measure gross profit margin as a percentage using the following formula:
(Revenue - Cost of Goods Sold) ÷ Revenue x 100 = Gross Profit Margin %
How to calculate gross profit margin
Before we calculate an example gross profit margin, here’s a refresher on some key accounting terms you need to know:
- Cost of goods sold: Cost of goods sold is the direct cost of producing or purchasing inventory for resale. Cost of goods sold should also include materials and labor.
- Gross profit: Gross profit reflects the amount of revenue remaining after your cost of goods sold has been subtracted.
- Revenue: Revenue is the income your business earns from the goods and services it sells.
- Income statement: Your income statement is one of three main financial statements that should be run after each accounting period. An income statement shows the profitability (or loss) of your business for that specific period.
The easiest way to calculate gross profit margin is to use accounting software. While accounting software does not calculate gross profit margin for you, it does offer easy access to accurate financial statements, where you can obtain the numbers needed in order to calculate gross profit margin for your business.
ABC Services Income Statement For the Period Ending 5-31-2020
|Cost of Goods Sold||$18,000|
For example, the income statement for ABC Services shows that the company’s revenue for the month of May was $49,000, and its cost of goods sold was $18,000, leaving it with gross profit in the amount of $31,000.
To calculate ABC Services’ gross profit as a percentage, you can use the following formula:
($49,000 - $18,000) ÷ $49,000 x 100 = 63.26%
If you’re not using accounting software, here are the steps you’ll need to take to calculate your gross profit margin:
- Calculate your revenue for the month. Revenue is the money received for goods and services sold. Do not include any other income in the calculation.
- Calculate your cost of goods sold. This is done by completing the following steps:
- Calculate beginning inventory. If you’re calculating inventory for May, you’ll need total inventory as of May 1.
- Add inventory purchased during the month of May.
- Add direct labor costs for the month. Only add direct labor costs, such as employees on an assembly line. All other employees are considered operating expenses.
- Subtract ending inventory costs as of May 31.
- Calculate your cost of goods sold.
- Subtract your cost of goods sold from your revenue totals to obtain gross profit in dollars.
- Use the gross profit margin formula to calculate gross profit margin.
What does your gross profit margin mean?
An average gross profit margin is around 10%, with over 20% considered good. For example, if ABC Services has a gross profit margin of 63.26% for the month of May, it means the company was able to convert more than 63% of its revenue into profit.
The higher the gross profit margin, the more money a business has left over to pay for operating and administrative expenses.
When analyzing your gross profit margin, keep in mind that it will vary widely by industry. For example, the average gross profit margin in the retail industry isn’t the same as the average gross profit margin in the manufacturing industry.
So, if you want to compare your gross profit margin, make sure you only compare it with similar businesses in your industry. It’s also important to calculate gross profit margin regularly since that will allow you to take proper action should it start to drop.
Gross profit margin is an important measurement for your small business. Why not start using it today?