profit margin of your business

The Meaning and Use of Gross Profit Margin


As a small business owner, you might decide to outsource some of your company’s accounting and financial management tasks. While there is nothing wrong with doing that, and we encourage it for busy business owners, we believe you still need a basic understanding of the associated accounting a financial management processes. As professionals in Accounting and financial management, we often encounter small business owners who don’t understand concepts like depreciation expense, goodwill, debits/credits, and ratio analysis. A lot of business owners don’t completely understand the concept of gross profit margin. We mention this gross profit margin ratio specifically because its the one financial management metric that business owners need to understand to help them drive their businesses towards maximum profitability. In the sections below, we are going to engage in a meaningful discussion about the concept of gross profit margin. We will take you through the definition, calculations, and how you can use it as a small business owner to make better business decisions.

The Definition of Gross Profit Margin

When we use the term “gross” sales, we are referring to a number that describes the gross amount of income a business makes on the sale of its goods or services over a specific period (day/week/month/or fiscal year). This number represents the income side of the gross profit margin calculator. The other side or part of the calculation would be the gross or direct costs the business incurs. The term “direct costs” refers to the actual amount of money it takes the company to manufacture or purchase all of the products sold. Manufacturing costs would generally include fixed costs like manufacturing materials and direct wages. If a small business serves as a middle man, they would buy products (direct costs) that they could resell to an end-user. As it relates to providing a service, the direct costs would be the time in wages the business required to provide the services. After calculating both gross sales and gross or direct costs, it’s then possible for someone to calculate the company’s gross profit margin.

The Gross Profit Margin and Percentage Calculations

Moving forward, we are going to focus on the production and sale of goods only. As you can see from the above information, the concept of gross profit margin also extends to service providers. It is important to note that while we will be talking about gross profit margins in terms of a company’s overall profitability, the same concepts apply all the way down to the product level. The first step you would need to fellow to calculate your gross profit margin would be to first determine your gross profit. Stating it verbally as a formula, the gross profit calculation is the difference between the total amount a business collects from the sale of its products minus the direct expenses it incurs to manufacture or purchase the products that the company sold. With the gross profit amount, you can further calculate a quasi ratio, the gross profit margin. This margin is often expressed as a percentage of gross sales. Stating it verbally as a formula, you would calculate gross profit margin by taking your gross profit and dividing it by gross sales. This will result in your company’s gross profit margin percentage. The higher the profit margin, the better for your company. Here is an example of both the gross profit and gross profit margin calculations by the numbers. Let’s say company A has $100,000 in gross sales of products that cost a total of $60,000 to produce: The gross profit would be $100,000 – (minus) $60,000 = $40,000 The gross profit margin would be $40,000 / (divided by) $100,000 = 40% FYI: In some industries, a 40% gross profit margin might be very good while maybe not so good in other industries. If you wanted to take things one step further, you can also calculate your company’s net income margin. To do so, you would only need to subtract selling, general, and administrative costs from your gross profit to come up with your company’s net profit. If you take that number and divide it by gross sales, you would then have your net income margin, which is again as a percentage.

Why is Gross Profit Margin Important?

In business, information is necessary to help business owners/managers drive a business towards profitability. Each calculation and ratio provides a picture of some aspects of the business cycle. The gross profit margin measures the ability of a business to efficiently use its manufacturing resources (raw materials, labor) to create gross income. This is very important information for a manufacturing business that has to compete is a highly competitive industry. Theoretically, the companies with the best gross profit margins are usually the ones that survive while other businesses fade away. Your company’s gross profit margin is going to be of interest to other people besides you. If you have partners, they most likely want to know how well the business is doing. Along with overall profitability, the gross profit margin tells a story about how management is running the business. A high-profit margin is indicative of a well-run company. Partners like that. They like knowing their company is in good hands. A company’s gross profit margin is also important to existing and prospective lenders. When lenders are making lending decisions, they have limited risk tolerance. Before lending to manufacturing concerns, they like to know their borrower has healthy margins as well as other profitability ratios. By the way, they will use these margins in comparison with industry standards. It’s the best way they have to determine if their borrower or a prospective borrower is going to be able to remain competitive and profitable going forward.

Using the Gross Profit Margin to Make Business Decisions

At the end of the day, the use of ratio analysis helps business owners make important decisions. The gross profit margin by itself often drives key decisions like product mix and pricing. As an example, let’s say a business owner finds out their company’s gross profit margin is lagging below industry standards. This tells a story. Either the company is selling its products below the competition or its manufacturing costs are too high. With this information, the business owner and or management can look to increase prices or lower costs by seeking other suppliers or laying off employees. If a company sells multiple products, they can use product level gross profit margin analysis to identify products that are both helpful and adversely affecting the company’s bottom line. We hope you have a better understanding of the concept of gross profit margin. We further hope you will use this calculation to help you make better business decisions in the future. Remember: while accounting and financial management concepts can be complicated and difficult to understand, learning about them could serve you and your company well in the future.

FAQ

What is gross profit on an income statement?

The gross profit percentage is found and labeled as to its own line in the income statement. Compared to the cash flow statement, the income statement does record the total revenue from sales, the direct expense, or cost at the moment of the transaction. As opposed to the cash when it is actually on hand. Therefore, if a credit sale occurs, it is immediately visible on the income statement. By revealing the financial results of a business for a given period, and thus knowing where the operating expense can best go.  It is possible to choose the amount of time to apply to the statement. It can be monthly, bi-monthly, semi-annual, annual, etc. The gross profit has to come from here, so you can analyze the gross margin better.

Is margin same as profit?

The profit margin acts as a measure of a company’s profitability. It measures how much a company maintains in profits for each dollar of sales that generates. On the other hand, we have the profit, which is measured in dollars and cents, the profit margin is measured as a percentage. A formula can help anyone better understand profit: total income minus total expenses equals profit. It is meaningful for any business, especially small businesses, to get to know its profit margin. Increased income does not always lead to higher profitability. When a company is aware of its profit margin, it is better positioned to control costs and make influential sales to plan for increased net revenue.

Is 30 percent a good profit margin?

As many industries, such as accounting and legal agencies, usually produce higher operating profit margins as they require such overhead costs, a good gross margin is weighed against any estimates for many other enterprises, including in the same sector. A good margin may differ depending on the business sector, however, a ten percent net profit margin is recognized as average gross profit margin by a general guide, a 20 percent margin is associated with a higher risk (or “suitable”), and a 5 percent margin will be known as a low gross profit rate. Afterward, all those regulations differ substantially based on the size of the industry and could be strongly influenced also by a range of other factors.

Is a high gross margin good or bad?

A company with a high margin is not bad. With a higher percentage, the company for each income holds more retention over net sales, to meet other expenses and obligations. Staying consistently high is a reflection of how productive the pricing strategy is and how well the operating cost is managed. Typically, a company that operates at a high margin of profit will sell fewer units than a company with a low margin. High-margin products sell for much more than the cost associated with acquiring and maintaining them, and total sales may be low since sales revenue is usually sufficient to cover all expenses related to the products for the high selling price and value. Businesses usually prefer this model since it does not require a large volume of sales to make a profit. High-margin businesses also do not care much about competition, as it means that a company is getting a higher return on sales for quality and excellent customer service because of its high net margin.

Should your business use the weighted average cost method?

A business needs the weighted average cost method when it is not possible or convenient logistically or operationally. As this attempts to smooth or homogenize the cost of sales reported by the company. Which results in a few subtle changes to net income at the same revenue levels. This method serves to control the flow and the production cost of items that make up the entity’s inventory by assigning it to all a common basis. It implies a similar or proportional treatment to items in stock regardless of their entry date into the system. Treating the cost of goods sold, the inventory in stock, in the same way at valuation time. In this sense, its choice must be documented in the accounting policies of the entity.