Understanding gross profit margin can be challenging to new business owners, but it’s critical to knowing whether your business is efficiently producing products and growing at the pace you desire.
Calculating Gross Profit Margin
Business owners use gross profit margin to set prices at levels that ensure a strong profit or as a measure to try to reduce cost for better profitability. It’s also helpful when determining whether you can charge enough for a new item to make it profitable.
To find your gross profit margin, you first need to calculate your gross profit. Gross profit is the amount you have after you subtract all the costs associated with the sale:
Gross profit = sales - cost of goods sold
The cost of goods sold, or COGS, includes only the direct cost incurred to manufacture or sell a product. COGS includes items purchased for resale or those used to manufacture a product as well as the direct labor cost to produce the product. It does not include operating expenses such as rent, utilities, and indirect labor.
By itself, gross profit is hard to use in forecasting and price determination because it is simply a dollar figure. But you can use it in many ways by calculating the gross profit margin, which expresses gross profit as a percentage, allowing you to spot profitability trends over time:
Gross profit margin = gross profit / sales x 100%
Using Gross Profit Margin
Calculate GPM when you review your monthly and quarterly financial statements. Even if all costs are covered and net income is strong and growing, watch for changes in GPM as an early sign that an increase in COGS is eroding your ability to remain profitable.
A high GPM helps you cover your business’s operating expenses and invest in areas that create even greater business growth, such as marketing and research and development. A low GPM shows that little of the sales revenue is available to cover operating expenses. Some businesses, such as grocery stores, have low GPMs and make money by selling a large volume of items with small markups. Compare your GPM with industry averages to stay competitive.
To increase your business’s GPM, you can use a combination of approaches:
- Increase the number of units sold (sales volume).
- Reduce elements of COGS. To do this, substitute cheaper materials, use less labor, and so on.
- Raise prices. Divide COGS by GPM to find the current markup. Try different markups in the equation until GPM reaches the desired level: Markup = COGS / GPM.
Regular, detailed examination of GPM and how its components change over time can assist you in highlighting opportunities for improvement in operations and profitability.
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