If you own a business, monitoring your profit margins regularly will give you the valuable data you need to identify the most lucrative areas of your business and scale them.
"Understanding your profit margins is particularly essential in navigating volatile times," says Claude Compton, founder of Pave Projects, a London-based hospitality group. "Having a deep understanding of your profit margins allows you to be adaptable and pivot at speed, while providing proactive leadership and fact-based decision making."
Here's a look at how to calculate gross profit.
How to calculate gross profit
The gross profit margin calculation measures the money left from the sale of your goods or services, once the operating expenses used to generate them are deducted (e.g. labour and material costs). Gross profit is calculated by subtracting the cost of goods sold (COGS) from the total revenues. Let’s look at each of these in more detail.
Cost of goods sold (COGS)
The cost of goods sold refers to all the direct costs and expenses involved in producing or delivering your goods and services. It does not include indirect costs, such as staff salaries or sales and marketing. Below are some examples of COGS:
- Raw materials or parts needed in manufacturing
- Direct labour costs associated to production
- Shipping costs
- Time spent assisting a client
- Equipment costs involved in production
- Utilities for the production facility
It is the total amount of income your company generates from the sale of your products or services. It shows you clearly how much money you’re bringing in from your total sales. It does not include the costs of running your business, such as taxes, interest and depreciation.
What is the gross profit formula?
The gross profit formula is: Gross Profit = Revenue – Cost of Goods Sold.
What is the gross profit margin formula?
The gross profit margin formula, Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue x 100, shows the percentage ratio of revenue you keep for each sale after all costs are deducted. It is used to indicate how successful a company is in generating revenue, whilst keeping the expenses low.
Gross profit margin formula example
As an example of gross margin, a shoe-maker might sell a pair of shoes for £50. They cost £15 to make, yielding the retailer a gross profit of £35. This equates to a margin of 70%.
- Total product revenue: £50
- Total production costs: £15
- Gross profit: 50-15 = £35
- Gross profit margin: 35/50 x 100 = 70
Let’s take a service-based business. Imagine the company is an accounting firm that audits other businesses. A single audit sells for £500 and costs £100 to produce, yielding a gross profit of £400. This is a margin of 80%.
- Total product revenue: £500
- Total production costs: £100
- Gross profit: 500-100 = £400
- Gross profit margin: 400/500 x 100 = 80
Why the gross profit calculation is important
The gross profit margin varies across products and sectors, and is often used to measure the profitability of a single product. It indicates how efficiently you are using your resources to produce your goods or deliver your services.
“If a business has a number of projects, or a number of products, then reporting on each separately is a great way to ensure that each component of the gross profit margin is performing as it should be,” says Compton. “Often, a lower result is due to one or two projects or products not being as profitable as expected.”
A strong understanding of your margins in business allows you to make quick decisions to support the growth and resilience of your company. For example, a spike might indicate a new trend that warrants additional investment, whereas a decline might highlight rising expenses, prompting you to analyse your cash flow and make cuts where necessary.
“We look at gross profit margins and specific key performance indicators in real-time daily and review in more detail on a weekly basis,” says Compton. “This regularity allows the business to ride-out changing tides and isolate any issues before they become a long-term problem.”
As an example, by analysing your margins, a business will be able to pin-down related price increases due to unexpected economic disruptions.
Marketing costs and the gross profit formula
The gross profit margin formula only includes the variable costs directly tied to the production of your goods or services. Wider company expenses, such as paying for the corporate office, are not included in the final metric. Instead, these expenses sometimes show on an income statement as ‘Selling, General and Administrative’ costs. These can include the wages of employees such as accounting, IT and marketing as well as advertising and promotional materials. It also includes any rent, utilities or office supplies that are not directly used to create a specific product. This means marketing costs are generally not included in the gross profit formula.
However, just because marketing and other indirect costs aren’t factored into the gross profit calculation doesn’t mean you shouldn’t keep a close eye on them too. These ‘costs of doing business’ affect your cash flow just as much as expenses that are directly related to products and services.
One way to cut down on the time it takes to track these indirect costs is to set up real-time expense reporting so you know what’s being spent company-wide, as well as card payment reminders so you know what needs paying and when. You can do both of these things easily using the digital expense management tools that come with the American Express® Business Card.
What is a good gross profit margin?
A study of over 13,000 retailers found an average gross profit margin in retail of about 53%. But this varied widely by product type. For auto and truck manufacturers, the average gross profit margin for the last quarter of 2020 was about 14%. For consulting services it was an average of 96% for the same period.
A high gross profit margin generally indicates you’re making money on a product, whereas a low margin means your sale price is not much higher than the cost. But it’s important to remember that while these figures are a useful reference, margins vary widely by industry and company size.
To learn more about gross profit and how to manage it strategically for business growth read our latest article What is Gross Profit? Everything You Need to Know.
Knowing how to calculate your gross profit margins helps you to better manage your cash flow, ensuring there's always enough money to pay your suppliers and expenses on time. The American Express® Business Card has up to 54 day payment period, giving you more control over your cash flow and when you make your payments¹. Find out more here.
1. The maximum payment period on purchases is 54 calendar days on The Business Gold and Platinum Charge Cards and 42 calendar days on the Business Basic Charge Card, it is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date.
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