This article contains general information and is not intended to provide information that is specific to American Express, or its products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.
Gross profit margin may be one of the first profitability metrics on an income statement — and it may be a useful one. It can show how efficiently your business turns production into profit. Owners may use it to spot their higher-margin products, guide pricing, manage costs, and benchmark performance, whether they're holding steady or seeking ways to increase profits.
What Is the Gross Profit Margin Formula?
Gross profit margin is used to measure what percentage of each sales dollar is left over after covering direct production costs. The formula is:
Gross Profit Margin = [(Revenue – Cost of Goods Sold) / Revenue] × 100
- Cost of goods sold (COGS) covers direct production expenses: raw materials, components, labor, warehouse costs, and returns. It doesn’t include indirect costs like administrative expenses, selling expenses, advertising, and legal fees.
- Revenue is the incoming funds from selling products or services.
Note that “Revenue – Cost of Goods Sold” equals gross profit, so you may see the gross profit margin formula written as [(Gross Profit / Revenue) x 100]. Both formulas should yield the same result.
Gross Profit Margin Formula Example
Here's how gross profit margin works in practice, using a shoemaker as an example:
Determine total revenue. Add up all sales for the period. Our shoemaker generated $200,000 in revenue last quarter.
Calculate COGS. Include all direct costs. The shoemaker spent $85,000 on materials (leather, rubber, laces, metal), labor, and manufacturing expenses.
Calculate gross profit margin. Subtract COGS from revenue, divide by revenue, then multiply by 100.
[($200,000 – $85,000) / $200,000] × 100 = 57.5%.
For every dollar in shoe sales, the business retained 57.5 cents. The business used those funds to cover rent, insurance, and marketing – banking the rest for an upcoming slow season. The owner also used the same margin calculation to plan appropriate markups and set prices.
Why the Gross Profit Margin Calculation Is Important
Gross profit margin can help measure how efficiently a business is using its resources to produce goods or deliver services. Some businesses may seem profitable due to high prices or sales volume, but if their input costs are just as high, they might not be earning as much as they think.
That’s why some businesses prefer tracking gross profit margin over gross profit alone — percentages may make comparison easier. A product line generating $50,000 in gross profit sounds good, but is that on $100,000 in sales (a 50% margin) or $500,000 (10%)? Margins may reveal efficiency, regardless of scale.
This analysis could inform several aspects of strategic planning:
- Allocating resources. Comparing margins across products may help businesses focus on high-earning offerings and phase out underperformers.
- Benchmarking performance. Analyzing internal margins against industry averages or competitors may highlight the impact of spending decisions and cost control efforts.
- Guiding pricing decisions. If margins are shrinking, the business may need to raise prices or find places to cut production costs to maintain profits.
- Spotting issues. Declining margins may signal rising costs, inefficiencies, or pricing pressure. Spiking margins, on the other hand, may point to untapped potential.
- Forecasting and planning. Consistent margin data could help predict future cash flow and inform expansion, hiring, or investment opportunities.
What Is a Good Gross Profit Margin?
A “good” gross profit margin varies widely by industry and business model. A high margin could mean the business earns money on each sale — but depending on the model, even low margins may work if volume covers other costs. The key is comparing your margins against businesses with similar revenue and customer bases.
Regardless of industry, a negative gross profit margin could be a red flag — it means the business loses money on every sale. While a business could recover from short-term losses (selling loss-leaders to draw in customers, or liquidating old stock), persistent negative margins could drag down net profit margins, threatening sustainability.
How to Help Manage Your Gross Profit Margin
Managing margins may start with understanding your current financial standing, then using that knowledge to help guide decisions. Pressures like supplier costs, pricing decisions, and operational inefficiencies directly affect margins, but they’re also levers you may monitor and adjust over time.
Monitor Your Profit Margins Regularly
Regularly reviewing gross profit margins — daily, weekly, monthly, or quarterly — could help make it easier to fix potential problems before losses compound. Consistent tracking may also reveal trends and shed light on why margins are changing. That could help put the business in a better position to capitalize on evolving profit opportunities, such as jumping on new demands or switching to more affordable suppliers.
Margins may reveal efficiency, regardless of scale.
If you’re tracking manually, you may consider using an accounting platform with a built-in gross profit margin calculator. Some platforms also include other profitability metrics like operating margins and net profit to help paint a fuller picture of financial health. Automated calculations could make it easier to distinguish between cyclical market fluctuations and genuine shifts in demand when planning prices, forecasting costs, and adjusting operations.
Use Profit Margins as a Tool
Profit margins may act as both a performance benchmark and a management tool. Margin analysis may help you prioritize strategies such as moving old inventory, increasing average basket size, or identifying which products to promote.
For example, retailers might consider selling certain products at slim margins to attract customers, then bundle those items with higher-margin goods to help boost overall profitability. Service businesses might consider taking a similar approach: Consider setting introductory pricing that breaks even, then improving margins over time through upsells and retention.
Build Them into Your Business Model
Margins may need to be built into the business model, not discovered after the fact. It may help to make them a core part of planning, forecasting, and decision-making, from setting prices and managing costs to mapping growth.
A budget retailer might plan for thin margins offset by high volume and low overhead. A premium brand might target higher margins supported by quality and perceived exclusivity. Either approach could work if pricing and growth strategies are designed around those margin targets from the start.
Keep a Long-Term Record
Keeping long-term margin records could help you identify patterns and plan ahead. You might notice, for example, that margins dip every Q1 because a key supplier raises prices in January. With that data, you could consider adjusting pricing or promoting higher-margin goods before profits are squeezed.
The longer you track, the sharper forecasts could become. Seasonal trends, regional differences, and product-level performance may get clearer over time, helping to build a stronger foundation for decisions about inventory, marketing spend, and pricing.
Ways to Improve Gross Profit Margin
If margins consistently lag behind competitors or targets, there are strategies businesses may consider to help improve profitability:
- Revise offerings. Think about using margin and sales data to double-down on high-margin products and improve or phase out under-performers.
- Renegotiate with suppliers. Consolidating vendors or renegotiating delivery schedules could help lower procurement costs, which could help reduce COGS and in turn could improve gross profit margin.
- Increase sales with existing customers. Bundling, minimum order thresholds, volume discounts, or complementary product pairings could help increase average basket size without raising prices.
- Increase operational efficiency. Automation, process improvements, and better inventory or labor management could help reduce per-unit costs over time, potentially increasing margins.
- Raise prices. If market conditions allow, gradual price increases could improve margins — but price changes may require careful planning to help minimize volume loss.
Each strategy could be adapted to your specific situation. A retailer may not be able to reduce supply costs, and a service company may struggle to upsell contracted customers. Be careful that short-term tactics don’t undermine long-term customer relationships.
The Importance of Cash Flow vs. Profit
Gross profit margin could help show whether the core business model works, but it may not tell the whole story. A business may have healthy margins and still struggle to pay its bills if cash is tied up in inventory or receivables.
That’s where cash flow comes in. Gross profit margin measures what you earn on each sale, while cash flow tracks when that money actually hits your account. Both matter for staying solvent.
Photo: Getty Images
The material made available for you on this website is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.
