A Quick Refresher on Gross Profit Margin

It’s difficult for a small business owner to know where they are going if they don’t have a full understanding of where they have been. That’s why accountants and financial analysts play such an important role in helping small business owners guide their business into profitability. There’s a lot of ways for business owners to measure the way their businesses are performing. Each line item on a financial statement has a very specific meaning. It tells a story about some aspect of the business and how it operates. To enhance the meaning of numbers, financial professionals have developed several meaningful calculations in the form of what they refer to as ratios. These ratios provide a fast and easy way for business owners, banks, and government regulators to see how a particular business has been performing. As you contemplate where your business stands today, we thought it would be useful to provide you with a reminder of how to calculate and use one very important ration called gross profit margin. Your company’s gross profit margin offers you and others insight into how effectively and efficiently your business is performing. In the sections below, we would like to give you a quick refresher about the concept of gross profit margin. We hope you will find this information useful as you make key business decisions in the future.

Understanding Gross Profit

Before you can learn how to calculate a gross profit percentage, you need to first understand the meaning of gross profit. As a business owner operates their business, they sell goods or provide services. In the process of doing so, they bring in revenue and incur certain expenses, often referred to as “cost of goods sold” or “cost of services rendered.” Gross profit is calculated as follows: Gross salesCost of goods sold = gross profit To simplify the following explanation, we want to focus on a business that sells sneakers. Here is an example that will hopefully paint a proper picture of how to calculate your company’s gross profit: Company A sold 100 pairs of sneakers at $20 a pair. The cost of manufacturing those 100 pairs of sneakers was $10 per pair. Let’s calculate the company’s gross profit: $2,000 (gross sales) – $1,000 (Cost of goods sold) = $1,000 (gross profit) If this were a stable business, the business owner could rightfully expect to make a gross profit of $1,000 for every 100 pairs of sneakers their company sells. That information is important because it gives the business owner a sense of direction. Before we move forward to discuss a gross profit rate or gross profit ratio, we want to explain the cost of goods sold in more depth. The cost of goods sold is comprised of two types of expenses, variable and fixed. Variable expenses are incremental amounts a company will incur with each unit they manufacture or purchase. Typical variable costs include shipping costs, manufacturing materials, and direct labor costs (factory laborers, commissions to salespeople). Fixed expenses are expenses the company expects to incur no matter how many units they manufacture or sell. The most common fixed costs will generally include office salaries with payroll taxes and benefits, facility rent, property taxes, utilities, office supplies, and insurance. All of these expenses combined make up the cost of goods sold. The only business expenses not included in this number would be things like business income taxes, amortization, and asset depreciation.

How to Calculate the Gross Profit Rate

Once you know your company’s gross profit, you can determine your company’s gross profit margin. By converting the gross profit to a gross profit percentage, you will be better able to make useful industry comparisons to see how your company is performing against the competition. The gross profit ratio is calculated as follows: Gross salesCost of goods sold (gross profit) / gross sales = gross profit margin. Using the same information from the aforementioned example, here’s Company A’s gross profit margin: $2,000 (gross sales) – $1,000 (Cost of goods sold) / $2,000 (gross sales) = .50 or 50%.

Practical Uses for the Gross Profit Percentage

The importance of your company’s gross profit margin will depend on your willingness to use it to make important business decisions. You might be asking yourself, “what is a good profit margin?” Well, that depends on the industry in which your company is competing. If you sell sneakers, your competition might be major footwear manufactures like Converse and Nike. If the normal gross profit margin within your industry is 75%, a 50% profit margin would not be healthy. Conversely, a 50% profit margin in the sunglasses industry might be quite healthy if other companies within the industry are operating with gross profit margins around 40%. As a good business operator, you should be using such ratios to help you make business decisions. Let’s take a look at some practical applications of the gross profit ratio. We’ll stick with the same example. Let’s say you manufacture and sell sneakers at a 50% gross profit margin. The industry standard is 75%, and you would like to benefit from having the same kind of gross profit margin. There are two things you can do to increase your gross profit margin. The easier option would be to increase your prices. If you are selling quality sneakers below-market prices, you should have some room to increase your prices and bring in more sales revenue without losing market share. That would effectively increase your gross profit margin. Of course, you are competing for customers. The marketplace will restrict your ability to increase your selling prices if the quality of your company’s sneakers is not comparable to the competition. In that case, you might want to consider lowing your costs related to producing and selling your sneakers. Even the slightest savings will serve to increase your gross profit margin to some extent. How would you go about lowering your company’s costs? You might start by negotiating better contracts with your vendors and suppliers. If that’s not possible, you might have to consider lowering your company’s fixed costs by as much as possible. If neither of the above options is possible, you might resort to a small price increase to be complemented with a slight lowering of expenses. The point is you will want to use your gross margin to help you decide how to move your business forward in the future. At first, it can be intimidating to look closely at your financial data in a meaningful way. If it’s not something that comes naturally to you, we can help educate you. Over time, you will find that using ratios to make important business decisions will become second nature to you. When you hit that point, you will have earned a “degree” in business management 101.

FAQ

What is the difference between gross profit margin and gross margin?

Many people are initially confused into believing that the gross margin and gross profit margin are the same, but there is an significant difference between them. Gross margin is what we calculate to know if the business is profitable. It is to know if the sale price of the product or service sold covers what it cost to manufacture the same product, i.e. the cost of production. Nevertheless, the gross profit margin is different because it is the percentage of the gross margin; we use the formula of the gross profit margin dividing the result by the sales, in order to know the exact gross profit margin percentage. These data must always be taken into account, even if we do not use them in the formula of this operation. They are mattering, such as fixed cost, the variable cost, direct cost, indirect cost, net income, total revenue, net sales, or total sale. Calculating what we want will allow us to find out if the company has the profitability, we are looking for and if it exceeds or stays away from the industry percentage, where the company is located.

Automatically calculate your gross profit percentages?

For any business manager to calculate the Gross profit or gross profit margin ratio is not a difficult task, as they are supposed to have the exact knowledge to calculate them. However, some applications and websites make this job easier in order to save more time. Websites or Excel, you only need to enter the necessary data that the formula asks for to automatically calculate the gross profit margin percentage. On the Internet, you will find a profit margin calculator, and there are many ones to choose from, but most of them work the same anyway. Finally, as a recommendation, it is important to know how to get the percentage even if you use an application that takes everything out automatically, knowing the formulas and why they are important and vital for the life of an entrepreneur. There are similar formulas but they do not end up being the same as the gross profit formula, the profit margin formula and the gross profit percentage formula.

What does it mean when operating income as a percent of net sales increases each year?

It means that your company has not only increased sales but also that there have been fewer expenses that affect your business. It is good news to know that the percentage of operating income has gone up, it means that the company is on a good track, is well-positioned and there is a good operating profit margin. However, it does not mean that calculating this percentage will answer all the questions. For instance, by means of this percentage, we are not seeing the exact profitability of the company and not knowing this would put the company at risk, since we would rely on data that helps but is not enough. If you really want to know if your company is being more profitable you have to take out more operations like the gross profit margin

How do you calculate gross margin in dollars?

It is basically the same to calculate it in dollars, you just have to subtract the income with the cost of the goods sold, but without forgetting that they are direct costs, i.e. direct labor cost and staff cost. Returning to the calculation, you have to do everything based on the dollar numbers and the result will be the gross margin in dollars. Now if you want to convert it into a percentage you simply do the same but add divide the total income and then multiply it by 100.  The gross margin whether it is in dollars or in percentage, you need to take it out and more for the financial analysts and accountants to make recommendations based on the results, also it would not hurt to take out net profit margin and margin of contribution.