As we kick off a new year and so many of us commit to maintaining or renewing our personal health, business owners may want to turn some attention to assessing the financial health of their company. Instead of using the scale or a doctor’s appointment to determine your starting point, a calculation of gross profit margin can give you a simple metric to indicate how your business is doing financially. This calculation takes into account total sales and the total cost of goods to determine fiscal wellbeing.
What Is Gross Profit Margin?
Before we get into calculating it, we should define what gross profit margin is:
Gross profit margin is how much a company makes as a percentage of every sale over the cost of goods sold (COGS).
Cost of goods sold includes anything that goes directly into the making or selling your product, including:
- Raw materials
- Production costs
Higher gross profit margins are usually a sign that your business is doing well because you’re making more money off your sales than you’re spending on your product.
Pro tip: Gross profit and gross profit margin are not the same. Gross profit is a dollar amount and gross profit margin is a percentage. So, for instance, a company may be making a gross profit of $200,000, but if their gross profit margin is 2%, then they’re not in a safe place if production costs go up.
Gross Profit Margin vs. Net Profit Margin
It’s important to understand the difference between gross profit margin and net profit margin, too. The net profit margin is also expressed as a percentage, and is how much of the net profits they’re making from revenue.
You can calculate net profit by taking your company’s gross profit (a.k.a. money coming in minus COGS) and subtracting operating expenses and any other costs, such as:
- Rent and utilities
- Research and development
- Debt payments
To calculate net profit margin, the formula is
Net profit x 100 / total revenue
It’s important to note that not all revenue translates directly into profit, which is shown through the net profit margin.
When calculating the net margin, you’ll find out how much of each dollar you earn through sales stays in your pocket. So a 25% net profit margin would mean you keep 25 cents of every dollar you make in sales.
Low margins for gross profit and net profit can point to a number of things, including a temporary slowdown in sales or variable costs in materials. Taking the average gross profit margin and net profit margin over time can help indicate if you need to adjust your bottom line.
Gross Profit Margin Formula
The formula for calculating gross profit margin is simple. The figures you need can generally be found on your income statement. You’ll first need to calculate your net sales and cost of goods sold (COGS). To establish net sales, subtract returns and allowances from gross revenue. To arrive at the cost of goods sold (which is sometimes referred to as “cost of sales”), add your beginning inventory to purchases made during the period you’re reviewing.
By subtracting your ending inventory from this figure, you’ll determine the sales COGS. Depending on your industry and the product or service you offer, you may need to consider some additional elements to calculate COGS. For example, materials, labor, and overhead/fixed costs (like rent and insurance) often are accounted for in this calculation. In a services business, labor, employee benefits, and payroll taxes should be considered.
What Is the Gross Profit Formula?
Take your net sales number and subtract your COGS. What’s left is your gross profit margin. Some prefer to express gross profit as a ratio. To calculate gross profit ratio, divide the figure you arrived at above by net sales.
Why Do You Need To Calculate Your Gross Profit?
As a small business owner, it is vital to keep a close eye on your financial statements. Taking the time to calculate gross profit margin lets you analyze your company’s profit potential. Knowing your gross profit margin gives you benchmarks on the path to a healthy net profit. When your gross profit calculation is high, your business is better positioned to realize a high operating profit margin and a robust net income.
If your business is new, pausing to calculate the gross profit margin can help you foresee when you will reach break-even and when you will begin earning an operating profit. The higher the margin, the sooner these important milestones will arrive. Banks and investors will also be impressed with a vigorous profit margin and may be more likely to partner with your company to support future growth.
Using the gross profit percentage formula can also help you decide on your company’s pricing strategy. It can guide you to capture the highest margin without sacrificing sales volume to maximize revenue.
Using the Gross Profit Formula for Your Business
Depending on your business model and whether your company sells goods or services, you may include different variables in your gross profit definition. Though the formula is the same, you will need to consider distinct components in your cost of goods sold .
Sales-oriented businesses may see an artificially inflated gross profit margin. This is because their operating expenses are elevated due to their business model’s increased dependence on product promotions. Rather than meeting an existing market need, sales-based businesses aim to create a need through marketing and advertising. The cost related to these efforts (headcount, ad purchasing, creative services, etc.) is not typically included in the cost of goods sold, but instead in the revenue cost. As such, these businesses will need to increase net sales and gross income to achieve business growth, keeping in mind that their profit margin may not accurately represent the company’s financial health.
Often, service-based businesses tend to ignore their gross profit margin because its calculation is a bit more subjective than it is in a product-focused business, involving more indirect than direct costs. Service-based businesses sell time. While some types of businesses like marketing and legal firms usually have an accounting system set up to track employee productivity and billing, many other service-oriented companies do not. Putting this type of system in place is essential so managers can course-correct when time isn’t spent wisely (e.g., an upper-level employee spending too much time on administrative tasks).
Time tracking is also necessary so that the business can calculate profit margin on specific projects to determine whether moving forward with certain clients is worthwhile or if some element of the project needs to be tweaked.
In order to support net profit growth, businesses should first focus on lowering the net sales cost (decreasing hours or re-balancing assignments based on billing rates) rather than increasing sales revenue by increasing pricing in order to achieve a more favorable profit margin.
What Is a Good Gross Profit Margin?
Profit margins vary significantly across industries. They can sway based on the company’s size, the season, the market conditions, and other factors. General criterion suggest 5% margin is low (anything below this is very low), 10% margin is average, and 20% margin is good. Again, these levels are wide-ranging and may not be relevant to your specific business.
Margin Vs. Markup
It’s important to differentiate between margin and margin markup. Margin is the difference between sales and COGS. So, if a product sells for $10 and it costs $4 to make, the margin is $6 or 60%. Markup is the amount by which the cost of the product is increased to arrive at the sales price. In the same example, the markup percentage would be 150% (markup amount divided by COGS). Often, these accounting terms are confused, resulting in an imbalanced financial statement or inaccurate pricing.
Final Word: Formula for Gross Profit Margin
Consistently monitoring your gross profit margin percentage is an essential activity for maintaining and enhancing your company’s financial health. This simple calculation can help you strategize for the future and should be done as regularly as accounting tasks like examining the profit and loss statement and reviewing fixed expenses and variable expenses. Using the gross profit formula may involve different variables depending on your company’s business model and whether or not you sell goods or services. As long as your internal calculations are consistent, this figure can provide a useful benchmark to guide you towards ideal pricing and lean internal expenditures.
Businesses should also regularly monitor their business credit report. Nav.com allows small businesses to access their free business credit scores to assess their financial standing and determine what methods of financing may help them grow in the year ahead.
This information can help empower your business decisions as your business enters 2023 and beyond. If you’re looking for small business loans or other business financing, Nav can help you find the right options for your needs, based on your business credit scores, annual revenue, and other data. Sign up for a free account today to start seeing your options.