Gross Profit Margin: Definition, Formula, Example & More!
Apr 25, 2023 | 7 min read | Leave a comment
Gross profit margin tells you how much percentage of profit you can make from one dollar in revenue after subtracting the cost of goods sold.
By looking at your gross profit margins regularly, you can understand how well you are at pricing your products and keeping your costs of goods sold in control.
But what gross profit margin actually is? How to calculate it? Why track it? Or How it differs from other margins like net profit margin or operating margin?
Don’t worry! In this article, we’ll answer all the questions above and more.
Without further ado, let’s dive right in!
What Is Gross Profit Margin?
Gross profit margin is a vital profitability metric that shows you how much percent of your revenue is left after deducting the cost of goods sold (COGS). The metric is presented under percentage value (%).
A high gross profit margin indicates that your business can significantly profit from its sales. In contrast, a low gross margin suggests that you might struggle to keep your direct costs at bay or face pricing pressure from competitors.
How to Calculate Gross Profit Margin?
The gross margin calculation formula is rather simple. You divide the Gross Profit by Total Revenues.
|Gross Profit Margin = Gross Profit / Total Revenue
And since gross profit is revenue deducted from COGS, the gross profit margin formula can also be expressed as:
|Gross Profit Margin = (Total Revenue – COGS) / Total Revenue
NOTE: To improve your gross profit margin, you must be able to notice abnormal fluctuations and make timely adjustments (e.g: switch to a new supplier when COGS gets too high). So, calculating it annually at the end of the accounting year isn’t helping.
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A Real-life Example Of Gross Profit Margin
To help you have a better understanding of gross margin, we’ll show you how to calculate the metric of IKEA – a huge furniture company based in the Netherlands. Below is the company’s consolidated income statement for the fiscal year 2021.
To calculate the gross profit margin for IKEA, we would simply divide the gross profit by the total revenue and multiply it by 100%.
(€4,478m / €25,615m) x 100% = 17.48%
So the gross profit margin for this company is 17.48%. This means that for every euro of revenue, the company keeps 17.48 cents in gross profit before taking into account other business expenses.
Why Track Your Gross Profit Margin?
The more frequently you track your profit margin, the more opportunities you can seize to improve your gross profit and, most importantly, your net profit. Proper gross profit margin tracking brings you tons of benefits, but chief among them, gross profit margin:
- Helps you monitor profitability: By knowing your gross profit margin, you can gauge your business’s financial performance. You can also identify areas where you need to cut costs or increase sales to improve profitability.
- Helps you make strategic decisions: Tracking your gross profit margin can help you make informed decisions about where to invest in your business. For example, if you have a high gross profit margin on particular items, you may allocate more resources toward marketing and sales efforts for those products.
- Provides a benchmark for performance: Comparing your gross profit margin to industry benchmarks and your historical performance can help you identify areas for improvement and measure the success of your business strategies.
What Is a Good Gross Profit Margin?
Though there’s no official data to back this up, a general thumb up is that a gross profit margin from 50% to 70% is considered good enough for manufacturers, retailers, and good producers.
However, you should be noted that average gross margin varies significantly by industry.
Service-based businesses tend to have higher gross margins than those selling physical products. This is because service-based companies like law firms or institutions don’t have to worry about the costs of goods sold.
For instance, business sectors like banking usually have a gross profit margin of up to 90% or more. Therefore, though a gross profit margin of 60% is remarkable for businesses selling physical items, it’s considered low in the industry.
To know exactly whether your gross profit margin is good or not, check the profit margin benchmark by industry for better reference.
How to Improve Your Gross Profit Margin?
Improving gross profit margin is crucial for businesses to sustain operations, invest in growth opportunities, and increase profitability.
- Increase prices: Raising prices can be a simple and effective way to increase gross profit margins, but it requires careful consideration of the impact on customer demand and competition.
- Reduce costs: Review your business expenses and identify areas where you can cut costs without sacrificing quality or customer satisfaction. Negotiate better deals with suppliers, minimize waste, and optimize inventory management.
- Improve operational efficiency: Streamline your operations by identifying and eliminating bottlenecks, automating repetitive tasks, and improving your supply chain. This can help you reduce labor costs and increase productivity.
- Focus on higher-margin products or services: Analyze your product or service mix and identify those with higher profit margins. Focus on promoting these offerings and phasing out or improving low-margin products or services.
- Upsell and cross-sell: Encourage your customers to purchase additional products or services by upselling and cross-selling. This can increase revenue and boost your overall gross profit margin.
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Some Limitations Of Gross Profit Margin
Although the gross margin is a useful financial metric, you should be noted that the stand-alone gross profit margin won’t give you a clear and complete picture of your business’s financial health performance.
Particularly, here are five big drawbacks of gross profit margin:
- Gross profit margin only considers the revenue and cost of goods sold (COGS) and ignores all other expenses such as marketing, R&D, etc. So a high gross profit margin doesn’t always translate into a high net profit margin.
- Inflation and deflation can affect your gross profit margin, as the COGS may fluctuate over time.
- Gross profit margin may give you a snapshot of your company’s profitability, but it doesn’t account for other important factors such as cash flow, debt, and investment in assets.
Overall, the gross profit margin is a valuable tool for assessing your company’s financial health. However, you should use it with other metrics to better understand your business performance.
Gross Profit Margin vs. Other Profit Margins
It should be noted that gross profit margin is different from net profit margin and operating profit margin, which are two other popular profitability ratios.
- Gross Profit Margin (GPM) represents the percentage of revenue after deducting the cost of goods sold.
- Net Profit Margin (NPM), on the other hand, is the percentage of revenue that remains after all expenses, including taxes and interest, have been deducted.
- Operating Profit Margin (OPM) measures the percentage of revenue after deducting operating expenses such as rent, utilities, and salaries.
While all three metrics provide insight into a company’s profitability, they differ in the expenses involved in calculations.
GPM focuses on the profitability of a company’s products or services, while OPM shows the profitability of the company’s operations as a whole. NPM provides a more comprehensive view of a company’s profitability, considering all expenses incurred in generating revenue.
Since the three metrics tell different stories about your business’s profitability, you should closely monitor them to stay on top of your business’s financial well-being.
All in all, gross profit margin is one of the most important profitability metrics that reflect your business’s financial health. And to improve your gross profit margin, you must monitor it regularly to spot abnormal ups and downs and make timely adjustments. For that, we hope after reading this article, you can have a better grasp of the metric and how to track it properly for your business.
Discover what proper profit-tracking looks like at trueprofit.io