How businesses measure success can vary widely, but the first metric that an outside lender or investor tends to look for is net profit, the bottom line of an income statement that shows the total amount left over from a company’s revenue after it pays all expenses. However important net profit is, though, it includes many variables that can get in the way of understanding the business’s core profitability. Gross profit measures the efficiency of that core – what the company is in business to do. For a company looking to analyze the profitability of an individual product, or its entire line of products, gross profit margin is therefore the better fit.
What Is Gross Profit Margin?
Gross profit margin measures the percentage of sales revenue that remains after subtracting all the direct costs of producing the products or services that were sold. The accounting term for those direct costs is “cost of goods sold” (COGS), and it includes expenses such as raw materials and parts, factory overhead and labor, warehouse costs, and returns allowances. Indirect costs, like expenses for selling, corporate offices, legal and other administrative fees, advertising, and shipping to customers are not considered COGS and so are not represented in the gross profit margin.
In simple terms, if a product sells for $5 and cost $2 to make, the gross profit for this item is $3 and its gross profit margin is 60% (3 divided by 5). This means that for every dollar earned in revenue, a company would expect to retain 60 cents and spend 40 cents. That 60 cents can be put toward any other company expenses or investments.
How to Calculate Gross Profit Margin
The formula for gross profit margin is simple:
Gross Profit Margin = Total Revenue – Cost of Goods Sold (COGS) x 100
Total Revenue
Gross profit often appears in the top section of an income statement, as shown in the hypothetical statement pictured below for the fictional Emily’s Electronics, because it includes some of the first elements of a business’s cash flow – the money coming in from sales and the direct costs needed to make the goods. Using gross profits, accountants and decision makers can see how much money they have for other operating costs, reinvesting, and other administrative costs, and allocate it accordingly.
The statement shows that Emily’s Electronics made $270,000 in revenue for the year. The cost of goods sold totaled $120,000, leaving $150,000 in gross profit. Dividing that by the revenue and multiplying by 100 gives us a gross profit margin of 55.6%. The shaded sections of the example depict details of operating income and net profit.
Gross Profit Margin Analysis
A number on an income statement isn’t always a helpful tool for financial analysis, but it’s a good starting point. When combined with historical data about the business, it can help to establish trends. For example, internal business analysts and external investors often use measures like gross profit margin to help forecast future cash flow. Typically, internal analysts look at profit margins monthly, after the books are closed and income statement data is settled. They use this data to dig into more specific gross profits, like by department or product line, to monitor profitability and determine how to improve the business’s margins. Such data can also be useful in forecasting future revenue and COGS.
Gross profit margin is best used in combination with other measures, such as operating profit margin and net profit margins, to create a fuller picture of the business’s financial health.
Digging deeper, small-business owners and managers often analyze gross profit margin over time to see whether selling prices and costs are growing at similar rates or if they’re out of sync. Shrinking gross margins over time raise a red flag. Gross margin is also used to compare product lines – it’s more profitable to invest in the product with the higher gross profit margin, assuming that other factors are equal. Company analysts also often compare actual gross margins to the expected margins reflected in the company budget, and then seek to understand the reasons for any deviation. Did selling prices go down due to discounts? Did costs rise? Is the business process less efficient than expected?
Meanwhile, a negative gross profit margin is largely seen as cause for concern. Such a scenario means your goods are costing more to make than they’re being sold for, so you’re effectively losing more money with every sale you make. Although a company can recover from such losses, if it isn’t immediately improved, the business may not be able to continue operating for long.
Ways to Improve Gross Profit Margin
It can be difficult, but not impossible, for businesses to improve gross profits. If a business is consistently showing lower margins than its competitors, here are the two main steps it may take to raise them:
- Reduce production costs. As companies grow, they may be able to order in bulk, establish better payment terms with suppliers, or increase their volume, all of which would reduce costs per unit. Other approaches, like switching to cheaper raw materials to reduce their COGS, can also raise gross profit margin. But care is required, as cutting too many costs during manufacturing risks resulting in an inferior product that pushes customers away, ultimately lowering revenue.
- Raise prices. Sometimes, especially in tougher economic times like inflationary periods, businesses with shrinking profits may have no choice but to raise prices. But how they go about it can make a big difference – especially to customers. When raising prices, it’s important to keep an eye on competitors’ prices to make sure you aren’t pushing customers toward cheaper alternatives. Gradually raising prices, especially if loyal customers get warnings ahead of time, may increase profit margins without hurting sales.
Limitations of Gross Profit Margin Analysis
Just focusing on gross profits can create problems for a business. Sales may be strong, but additional operating expenses or nonoperational losses can drive a business with healthy gross profits into the red. Operating costs like salaries for the sales team, distribution and delivery costs, and corporate offices need to be covered by gross profit funds. Additionally, businesses also need to cover nonoperating expenses with gross profit, like loan interest or lawsuit settlements.
So, while gross profit margin is an important measure of profitability for a business’s core operations – its products – it falls short of giving a full picture of a business’s health. Gross profit margin is best used in combination with other measures, such as operating profit margin and net profit margins, to create a fuller picture of the business’s financial health.
The Takeaway
Gross profit margin shows a business how efficiently it uses key inputs – materials, labor, factory overhead – to produce its core products. Gross profit is the money left over from a sale after the costs of producing the goods sold are paid. Those “leftovers” are then used for the company’s other operating and nonoperating expenses, or for reinvestment. Business leaders use gross profit margin trends to analyze a company’s profitability, both general and product-specific, and to forecast future sales and profits. External investors use gross profit margin to better understand the strength of the company’s financial foundation. Gross profit margins are useful tools for understanding a company, but they’re only one piece of a complex puzzle.
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