Gross profit margin is a percentage ratio that helps you understand the financial health of your business.
Put simply, it reveals what percentage of your total revenue is profit after paying the direct costs of producing your goods and services. This gives you an idea of how much revenue is left over to pay for operating expenses.
You need to regularly calculate and find ways to improve your gross profit margin to keep your business profitable. In this article, we cover the essential information you’ll need to do this effectively.
- How do you calculate your gross profit margin?
- Why is the gross profit margin ratio important?
- How do you analyze the gross profit margin?
- What constitutes a desirable gross profit margin ratio?
- How to improve your gross profit margin
- Gross profit margin in the context of start-ups
- The limits of gross profit margin
How do you calculate your gross profit margin?
Gross profit margin should not be confused with gross profit. The latter is the dollar amount of how much is left over after paying all expenses related to delivering your products or services.
In other words, gross profit is revenue minus the cost of goods sold (COGS), which includes materials, labor, shipping etc.
Note: COGS doesn’t include operating costs that your business needs to pay regardless of how many products are made. Things like office expenses, administrative salaries, or marketing, for example.
Gross profit calculation:
Gross profit = Revenue – Cost of goods sold
Once you’ve calculated gross profit, you can use this figure to work out the gross profit margin, which is represented as the percentage of overall revenue that qualifies as profit.
Gross profit margin calculation:
Gross profit margin = gross profit/total revenue x 100
Let’s get some example figures in there. Imagine your company generated $600,000 in sales one year, and it cost $475,000 to create those products.
Your gross profit would be:
$600,000 (revenue) – $475,000 (COGS) = £125,000 (gross profit)
This would make your gross profit margin:
$125,000 (gross profit) / $600,000 (revenue) = 0.2083 x 100 = 20.83% (gross profit margin)
This would mean 20.83% of the revenue you make is profit and can be used to cover operating costs.
Why is the gross profit margin ratio important?
Knowing your company’s gross profit margin helps you understand whether it’s financially healthy. And by tracking it over time, you can determine if you’re heading in the right direction or need to make improvements.
Another use is to benchmark your company’s financial performance against the rest of the industry. This can inform your decisions and help you set goals, like trying to achieve an average ratio if you’re a little behind or exceeding it if you’re already strong.
By proactively trying to grow your gross profit margin ratio, you can build a financial cushion that protects your business against fluctuating operational costs, like those tied to energy. You could also free up money to invest in areas like innovation or R&D.
How to analyze the gross profit margin?
Once you’ve calculated your gross profit margin, there are multiple insights you can gain from it. Each of these give you an idea of performance and can help you consider ways to grow profitability.
Here are a few things to look out for:
- Consistency: Does your profit margin fluctuate significantly over time? This could be a sign that the business isn’t being managed effectively, or that your products aren’t hitting the mark. Of course, if there’s an obvious cause to an individual fluctuation—like a sudden change in your business model or the introduction of new technology—then spikes or dips can be expected.
- Proportional growth: Check if any rise in revenue is accompanied by a proportional rise in COGS. If you find that costs are rising faster than revenue, you need to investigate why and try to keep the growth relative. If you ignore this, your profitability will take a hit and this can lead to some serious problems down the line, like being unable to cover operating costs. There are many reasons that COGS may start to increase faster than revenue, including sharp rises in the price of raw materials, or higher shipping charges.
- Below-average margin: If you’re worried that your gross profit margin ratio is lower than the average for your industry, you need to focus on improving it to stay competitive. Try to consider which areas might be harming your profitability. Are you not charging enough? Is production inefficient? Are there elements that could be automated?
What’s a desirable gross profit margin ratio?
This is a common question for business owners who are looking to grow their profitability. But there’s no single right answer. The truth is, all businesses are unique, and so the gross profit margin ratio alone only gives you an indication.
You might think a 20.83% margin is pretty good, but if that’s largely taken up by operating costs, there won’t be much left over for you to invest in other things.
So, it’s best to investigate the average for your industry, just to get an approximate benchmark. You can do some research into this, post some questions in an online business forum, and reach out to your network to find a common figure.
However, you should also combine the gross profit margin ratio with other financial ratios, like EBIT (Earnings Before Income and Taxes) and Net Profit to get an even greater sense of your position.
How to improve your gross profit margin
Here are 5 ways to push the gap between revenue and COGS and achieve a better gross profit margin.
- Review your prices
The question of whether to raise prices never has an easy answer. It almost always feels like a risk. If your current prices are in line with competitors, it’s understandable why you’d hesitate to raise them—especially if you’re in really a competitive industry where margins are typically small.
But sometimes you have no choice. If higher energy bills and raw material costs are pushing up your COGS, then your gross profit margin is going to reduce over time.
Sometimes, not raising your prices is also a risk. If your competitors face the same pressure and choose to sacrifice profit margin to retain customers, they could find themselves out of business soon. If you raise prices, you may lose some customers in the short term, but will be more financially stable over the long term.
- Produce more efficiently
An alternative to raising prices is to protect profit margin at the other end; by reducing your COGS as much as possible. There are many ways to do this, such as trying to automate processes and supporting your people with whatever they need to be more productive.
The key here is to achieve the same (or higher) output with less time and financial cost, without harming product or service quality. This might take some upfront investment, but you’ll likely recover this over time and have more efficient production going forward.
- Do things differently
Another approach to the pricing challenge is to stop competing on price. Reflect on your products or services and ask why should a customer choose you over competitors if price wasn’t part of their consideration?
Focus your efforts on differentiating your offering and then adjust your prices accordingly. Perhaps you improve product quality, refresh your brand, introduce a new service, or find ways to provide more value to customers.
Could your soap company introduce a range of new scents? Could you switch to sustainable packaging? Could you introduce a subscription service that saves customers having to re-order every month?
People will pay more for the products and services that will genuinely enhance their lives.
- Review your suppliers
The cost of supply can slowly creep up, and businesses often stop using tools, products, and services that they still pay for. A full review of all your suppliers can help you cut costs in unexpected areas. Is there anything you’re paying for that doesn’t add much value to your production process?
Another approach is to negotiate pricing with your current suppliers. If you can do this in a professional manner you might be surprised at what they can offer. You may be able to arrange a better deal, or strip back a plan to its essentials.
For any that you feel you are overpaying for, consider switching to new suppliers. Just remember to avoid changes that could compromise product quality or customer experience.
- Focus on upselling
It’s easy to focus your attention on winning new customers, but there is often a lot of opportunity to grow profit with those you already have. This is true for both product and service-based businesses, who can work to improve the customer experience and try to entice additional sales at the right time.
This could be through improvements to the buying journey on your website, adding more prompts or reminders around other products, investing in customer marketing, or even training sales or customer service teams to push more promotion.
Gross profit margin for start-ups
If your business is just getting started, it’s likely that your gross profit margin will be smaller, and its growth steady. This is especially true if your operations aren’t as efficient as they could be, which is common when you haven’t had years to develop and evolve them.
Another reason you might have low gross profit margins is that you’re unable to compete on price. When you don’t have an established brand and haven’t yet had the opportunity to build trust, it can be hard to attract new customers at the usual price point. Many startups will offer discounts, which impact profit considerably.
There are, however, some cases where your startup might achieve high gross profit margins. This usually happens if the owner of the business is not taking full payment, instead reinvesting the money back into the company. This is how many founders get their business off the ground in the first few years.
The limits of gross profit margin
Though useful in understanding your financial position and finding opportunities for improvement, the gross profit margin has its limits.
Remember that it is calculated using only COGS, which doesn’t include operating costs that are not directly related to production, like the accounting, HR, marketing departments etc. This means it can’t reflect the overall profitability of your business. Net profit is a much more reliable metric for this, as it includes every cost, including interest and taxes.
Another issue is that temporary fluctuations in your production costs can skew the accuracy of the gross profit margin. Let’s say the cost of a raw material spikes for 3 months, then settles down. This will make it difficult for you to use this period to accurately compare performance against future years.
Finally, the gross profit margin can only provide an approximate benchmark, as what is considered good in your industry isn’t always well defined. Not only that, but every business is different, and operating costs are also a significant factor that need to be considered. It’s even more difficult to compare your business to those in other industries using only this metric.
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