Gross profit margin is a calculation used to determine the profitability of your business. Find out why you should use this ratio today.
Gross profit margin is a metric that can be used to gauge business performance and efficiency. Gross profit margin, sometimes referred to as gross margin or gross margin, allows you to measure revenue against the cost of goods sold, which gives you a good idea of the profitability of your business operations.
Overview: What is Gross Margin?
One of the most important small business accounting tasks that every small business owner should perform is using various calculations that provide insight into the financial performance of your business.
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, by determining the amount of profit remaining after subtracting direct production costs.
To calculate your gross profit margin, you will need to calculate your total revenue and cost of goods sold for the accounting period. In order to get a more accurate picture of your business’s efficiency over time, you should regularly calculate your gross profit margin.
An important metric for business owners, gross profit margin is also a key metric for investors, potential investors, and financial institutions because it provides financial detail about a company’s primary business activities.
For example, a higher gross profit margin indicates that your business is financially sound and capable of producing products and services efficiently and profitably.
On the other hand, a low or negative gross profit margin can indicate many problems, including inflated production costs, too low prices, or generally faulty operations that prevent your business from making a profit on the goods or services you ‘ rev sell.
Gross Profit Margin vs Net Profit Margin: What’s the Difference?
Gross margin: All business owners want to know if the product or service they are selling is actually profitable. The best way to determine this is to calculate gross profit margin, which is the difference between revenue and cost of goods sold.
The gross profit margin calculation provides a clear picture of basic operating efficiency and profitability, with the results also showing the amount of profit remaining which can be used to cover other business expenses such as overhead or selling fees.
The net profit margin: More comprehensive than gross profit margin, net profit margin, or net margin, is the percentage of revenue generated by your company’s revenue after all expenses have been taken into account.
While gross profit margin is designed to measure the efficiency of your core business operations, net profit margin, or net margin, measures the overall profitability of your business, taking into account all operating, general and administrative expenses, including including interest and taxes.
While gross profit margin measures a company’s efficiency in producing and selling its products and services profitably, net profit margin provides a more realistic view of the company’s overall profitability.
The Gross Profit Margin Formula
Determining gross profit margin is a simple calculation with the option to calculate the 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 companies find it more useful 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 calculating an example gross profit margin, here’s a refresher on some key accounting terms you should know:
- Cost of Goods Sold: Cost of goods sold is the direct cost of producing or buying inventory for resale. The cost of goods sold must also include materials and labor.
- Gross profit: Gross profit reflects the amount of revenue remaining after subtracting the cost of goods sold.
- Revenue: Revenue is the income your business earns from the goods and services it sells.
- Income statement: Your income statement is one of three primary financial statements that must 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. Although accounting software does not calculate the gross profit margin for you, it does provide easy access to accurate financial statements, where you can get the numbers needed to calculate your business gross profit margin.
ABC Services income statement for the period ending 05/31/2020
Cost of Goods Sold
For example, ABC Services’ income statement shows that the company’s revenue for the month of May was $49,000 and the cost of goods sold was $18,000, leaving it with a gross profit 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 don’t use accounting software, here are the steps to follow to calculate your gross profit margin:
- Calculate your income for the month. Revenue is 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 performing the following steps:
- Calculate the initial inventory. If you are calculating inventory for the month of May, you will need the 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 the ending inventory costs as of May 31.
- Calculate your cost of goods sold.
- Subtract the cost of goods sold from your total revenue to obtain a gross profit in dollars.
- Use the gross profit margin formula to calculate the 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, that 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 to pay for its operating and administrative expenses.
When analyzing your gross profit margin, keep in mind that it varies widely by industry. For example, the average gross profit margin in the retail sector is not the same as the average gross profit margin in the manufacturing industry.
So if you want to compare your gross profit margin, be sure to only compare it with similar companies in your industry. It is also important to regularly calculate the gross profit margin, as this will allow you to take appropriate action if it starts to decline.
Gross profit margin is an important metric for your small business. Why not start using it today?