Gross Profit Margin and How to Calculate It

Susan GuilloryUpdated August 29, 2022

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Good business cash management includes understanding how much money you’re making for the products you sell, as well as how you can use that profit to grow your business. We’re talking about gross profit margin here, and if you’re not familiar with the concept, you may be doing your business a grave disservice.Let’s take a closer look at gross profit margin--and at why it’s so key to your business.

What Is Gross Profit Margin?

Profit, as you may know, is what’s left over from your revenue after you’ve subtracted all your costs and business expenses. But gross profit margin takes things one step further. It provides an indication of how well your business is managing its operations based on your cost of goods sold (aka COGS).To make things clearer, let’s define a few terms. First of all, net sales are, basically, your revenue--the amount of money your business takes in for selling its products minus the price of any returned goods or discounts you’ve offered. Direct costs are costs for things that contribute directly to creating a product. Let’s say you make homemade soaps. Your direct costs would be the ingredients (lye, scent, etc.) as well as the equipment you use to make the soap and the manual labor needed to produce it. Direct costs are your COGS. Indirect costs, by way of contrast, are those that don’t relate directly to your product but do support the overall operations of your company. This includes things like marketing expenses, internet access, and office equipment. Indirect costs are excluded from COGS.COGS may vary from product to product and your business's overall COGS can also vary from one year to the next. But whatever you’re measuring with it, understanding your COGS is key in calculating your gross profit margin. And in any case, the terms we’ve just reviewed will apply, as will the formula for calculating it.Recommended: What is Net Income? Definition, Calculation, and Example

How to Calculate Gross Profit Margin

Here’s the formula to determine your gross profit margin:((Net sales - COGS) / Net sales) X 100 = Gross profit marginYou start by looking at your net sales. Subtract your COGS from your net sales to get the top \ figure in the equation. Then divide that top number (net sales minus COGS) by your net sales. Finally, multiply the result by 100 to arrive at your gross profit margin (which is generally expressed as a percentage)..Here’s an example. Let's say your business’s net sales are $5,000 a month after returns have been factored out. And let’s say, also, that it cost you $2,500 in direct costs to make your inventory for that month. To calculate your gross profit margin:(5000-2,500) / 5,000 =2,500 / 5,000 =.5 (this number is also called your gross profit ratio).5 X 100 = 50% (gross profit margin) Your gross profit margin would be 50%. That means that for every dollar your business makes in total sales, 50 cents is gross profit (which doesn’t take into account indirect costs). Recommended: What are Retained Earnings?

How Gross Profit Margin Impacts Your Business

So why does gross profit margin matter? Simply put, gross profit margin is a measure of your profitability. It tells you (as well as potential investors) how well you’re doing in regard to your products. If your company’s gross profit margin is too low, it suggests that you’re either not charging enough for your products or your direct costs are too high. This could lead to financial strain down the road, so it might be a red flag to a potential investor.Your gross profit margin isn’t useful in a vacuum, however. It’s most helpful if you compare it, either to your gross profit margin during the same period of time in previous years, or to the gross profit margins of other businesses in your industry. Either way, the comparison gives you a benchmark to measure against as you move forward.However, if your gross profit margin varies widely from one quarter to another, this may be a concern to investors, since it could indicate that your company lacks solid management practices. However, another cause for a fluctuation in gross profit margin could be that you’ve made recent changes to how you operate that can account for the variations.Recommended: Cash Flow vs Profit

What Is A Good Gross Point Margin?

So what you likely want to know now is what is a good gross profit margin.A higher gross profit margin is generally considered preferable to a lower one. If your gross point margin is too low, it’s an indicator you’re not managing your capital structure well. What exactly counts as a good gross profit margin depends very much on what industry you’re in. As a rule of thumb, a company that makes products is likely to have a higher gross profit margin than a company that buys and sells products made by others, like a retailer. Electrical equipment manufacturers, for example, average a gross profit margin of 35%. Grocery stores, by way of contrast, average a gross profit margin of 25% to 30%. Recommended: EBITDA vs Gross Profit: A comparison

5 Ways to Improve Your Gross Profit Margin

Now that you better understand the importance of knowing what your gross profit margin is, it’s a good idea to work to optimize it so you keep a steady cash flow and have the funds you need to run and grow your business.

1. Work on the Perceived Value of Your Brand

All too often, companies race to the bottom, trying to win more market share by having the lowest prices. But low prices mean less profit, and that’s not sustainable for long.Instead, find ways to elevate your brand as one that is worth paying more for. There’s sometimes little difference between the ingredients in, for example, top-of-the-line cosmetics and discount cosmetics, but people are willing to pay more for a brand they see as offering a high-value product. Hiring a marketing agency, upgrading packaging, and/or investing in a website makeover are all tactics that may help upgrade your company’s image.

2. Raise Your Prices

This strategy will only be effective if you haven’t raised your prices too recently--like within the last few years. You may lose customers if you raise prices too often.See how much competitors are charging and decide where you want to fall among them. Especially if the cost of your supplies has risen, raising your prices slightly can help you keep your gross profit margin steady.

3. Negotiate Lower Supply Prices

You may be able to negotiate with your vendors for lower rates, especially if you buy in bulk. Also, look at other vendors who may be able to beat what you’re currently paying.You might also look at different, more affordable types of materials to make your products, as long as that doesn’t mean compromising the quality of what you make.

4. Identify Your High-Profit Products

If you take the time to analyze the gross profit margin for each product, you will be able to identify a few that have higher profit margins. These are the products you want to promote heavily. Highlight them in your marketing campaigns.

5. Add Other Products to the Mix

If you’ve been selling the same product for years and have struggled to see a higher gross profit margin, it may be time to add other products to your line. Find those that have higher profit margins and are easy to produce, as well as those that there’s a strong market for.

The Takeaway

Gross profit margin is just one key financial component that you need to stay on top of to ensure the financial wellbeing of your business. Other ones include your profit and loss, as well as debt to equity ratio and cost of capital.You don’t have to be an accounting guru to understand concepts like these. And the tradeoff for just a little effort is that being aware of how money is being leveraged in your business can help you plan for a successful future.Looking to grow with a small business loan? With Lantern's help, you can spend less time searching for financing and more time expanding your business.

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About the Author

Susan Guillory

Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.

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