What is a Gross Profit Margin?

Dear M &M:

I keep hearing about gross profit margin? What is it and how do you figure it? 

 

-William

Dear William:

A firm’s gross profit margin is used to measure a company’s financial health. It determines how much money the firm will have leftover to pay for other expenses after deducting the cost of goods sold. This will allow you to determine after producing the product how much money you will have to pay for other business expenses not directly related to the production or manufacturing of goods sold.

There are many industry standards that have been established one can use to see if your gross margin is in line with your particular industry or trade. This will enable you to adjust selling price or reexamine your procedures or expenses to produce goods for sale.  The formula is:  Gross Profit Margin = Revenue – Cost of Goods Sold /Revenue.

For example let’s say your company sold $1000 dollars’ worth of goods and you spent $500 in direct expenses to produce the goods for sale. Your firm’s gross profit margin would be 50% (1000-500/1000 or 500/1000 = .50). For every dollar the company earns they really have only 50 cents before other expenses incurred not directly related to the cost of goods sold.

Remember the cost of goods sold included material and labor to make the products you are selling.  Research and development, selling and general administrative expenses are not included in the production and are considered other business expenses and therefore are not included in the costs of goods sold. So it looks like in this example part of those 50 cents left over after deducting the costs of goods sold will be used to pay for some other business expenses.

Let us hope that your other expenses do not exceed 50 cents for every dollar in sales or in this example $500. What you have left after deducting your other expenses would be earnings before taxes. Every industry has different gross profit margins (GPM). A child care center has 42% GPM, Beauty Shop 55% GPM, Grocery Store 20% GPM, Pest Control 64% GPM, Tire Store 38% GPM and a Software Development Company’s GPM is around 80%.

In addition, every company will have differing cost of goods sold and different revenue amounts as pricing and cost to produce will vary. Industry ratios will give you a benchmark for comparison. Gross profit margin ratios should be monitored frequently to make sure you have a sufficient gross profit to cover selling, administrative and other operational expenses. Managers and business owners should know what their industry gross profit margin is as well as what their own company’s gross profit margin is.

One can calculate the value of incremental or future sales if you know what each unit or dollar in sales will generate to offset the cost to do these additional sales. Do not assume as sales go up your cost will remain constant. Remember a gross margin is a good indicator of your firm’s ability to pay operating expenses.

Comparing your gross profit margin to industry standards will enable you to adjust pricing policies accordingly. Looking into your industry labor costs as a per cent of sales, sales per square foot, inventory values, age of account receivables and other financial ratios would be a good idea as well as knowing all about gross profit margins.

-M&M

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