Regardless of whether you are an entrepreneur knitting woolly hats to sell on the side, squeezing your own orange juice to take to the marketplace, or you run a 5-star hotel and take millions in monthly turnover, the equation to determine your gross profit margin does not change, nor do the insights you can gain from this metric.
In ‘Accounting for Dummies’, John Tracy explains the gross profit margin to the layman as “(a percentage calculation)… determined by dividing your gross profit by the top line.” To complete our percentage calculation, we of course have to multiply our answer by 100. It is a simple enough equation, and has been used as an important insight by modern businesses for decades to gain a deeper understanding of their efficiency, and overall capability to create profit.
Going forward, we’ll look at how to work out the gross profit margin. We’ll see some examples of how to do the math, learn what makes a good or bad margin, and why it’s important for your business.
What is Gross Profit Margin?
Simply put, gross profit margin is a percentage that shows how much money a company makes after paying for its goods. If we briefly go back to Tracy’s simplified explanation, we can see we are missing some important details that bring us to our calculation.
To find our margin, we first need to know how much it costs to make or buy our goods. This is called the cost of goods sold (COGS). We also need to know how much money we made in total, which we call total revenue. With these three numbers – total revenue, COGS, and gross profit – we can work out our gross profit margin. But first, let’s understand what each of these things means.
Total Revenue:
In its most basic form, total revenue is the income a business generates. It does not take any deductions into account and is the rawest form of financial data available for us to figure out our gross profit margin.
Cost of goods sold:
The cost of goods sold takes into account the fees associated with the production of a product, more specifically, the cost of the materials required for production, and the labour hours involved. COGS does not take into account anything that would not cost you after your product or service is ready, even if it does not sell.
Gross Profit:
Gross profit comes from deducting your COGs from your total revenue, and it is the number we will need to figure out our percentage calculation. Once we have these figures we can put them into our gross profit margin equation, and start figuring out how a company is performing. We can also gain some insights into its efficiency versus its competitors – points we will explore more deeply later on.
How is Gross Margin calculated?
Gross Profit Margin = (Total Revenue – COGS) / Total Revenue x100
To get an idea of how the gross margin equation works in practice, let’s go back to our hat-making entrepreneur who is trying to generate some extra cash flow and break down some simple, hypothetical numbers to see what their gross margin percentiles are. Let’s start with the woolly hats. First, we figure the cost of goods sold (COGS):
(Materials) Spool of Wool – £3
Knitting needles – £1.50 Total = £4.50
(Labour) Completed in own time – £0
Our Entrepreneur knits 4 hats and sells them for £3 each. To figure out our total revenue, all we need to do is multiply the number of sales by the product sell price. (4 x 3 = 12).
Now we have our total revenue figure, we can put all the pieces together into the gross profit margin equation and get our percentage calculation.
(12 – 4.50) / 12 x 100=62.5% Gross Profit Margin
Regardless of the industry nor scale of the revenue, once your calculations are correctly figured and inputted into the gross margin equation, you will start to understand how your business is performing, not just compared to its competitors, but with itself, year on year.
Does My Company Have a Good Gross Profit Margin?
Due to industry differences, it can be difficult to make a generalisation for what a ‘good’ gross margin is. You could not expect a retailer that relies on frequent product purchases and sales to be reliably compared to the digital sector. Their COGS, services, and available products simply differ too drastically.
Using data from Statista, let’s look at the 2020-21 fiscal performance of two companies from these different industries. VF Corporation, a footwear company, and Anghami, a music streaming service. From 20-21 VF’s revenue dropped from 11 billion to 9.2 billion, with gross profit margin following the downward trend from 55.3% to 52.7%. Meanwhile, Anghami maintained a revenue of 36 million between 20-21, and as a result their gross margin remained at a stable 27% year over year.
During this fiscal year, VF lost 1.8 billion in revenue, 5 times the total revenue of Anghami, and only lost 1.6% of its gross margin, while still maintaining a much higher margin than Anghami. This demonstrates the disconnect between cross-industry gross profit margins, and it’s why this metric needs to be compared within a company’s niche.
To obtain more realistic financial insights, VF or Anghami would need to look both internally at their own year-on-year margins, and also at comparable names in their industry sector, and gather data from a large, relevant pool. If you find your gross margin is falling year-on-year, or is lagging behind your competitors, you should start focusing on the three factors we use to obtain the gross profit margin and explore what can be done to get your business ahead.
Why Does Gross Margin Matter for Business?
The gross profit margin shows key trends in how your business is doing. By looking at your margins over time and comparing them to other companies, you can see how well your company is making money. This information can help you decide if you need to make more money, cut costs, change your prices, or even think about tough choices like letting some workers go.
Let’s look at some important things to think about after you get your latest gross profit margin. We’ll see why these things matter for your business and what you can do to make your margins better.
What Business Insights Can Be Taken From Gross Profit Margin?
By considering and improving some of the following key factors that go into your gross profit margin, the overall health and strength of your company will continue to increase, maintaining your position as a serious competitor in your industry.
Material Costs:
Material costs are one of the primary contributors to your COGS. If your gross profit margin shows a dip year over year or you suddenly find yourself falling behind the competition, this is the first factor that should be considered. If you can secure cheaper materials by negotiating better prices or buying in bulk, or simply finding a better deal with suppliers, you can immediately relieve the strain on your costs and start to improve your margin.
Labour Costs:
The money you pay workers is a big part of your costs. You might think about ways to help workers do more. Or you could look at making jobs easier, maybe using machines or hiring outside help. But always think about how your workers feel and how changes might affect them before making any drastic decisions.
Discounts:
Moving to another significant part of our gross profit margin, overall revenue, we can consider factors like discounts to boost overall sales, ultimately increasing percentage. Although, while product discounts can increase sales volume, they will also reduce the selling price of your units. Without a decent marketing plan in action, you could lose money in the short term, so it’s important for companies to find the correct balance between discounts and sales made.
Supply Chains:
An efficient supply chain helps keep costs low by reducing factors like lead times and transporting costs. While a consistently well-managed system might not be an important factor if your company is performing effectively, if margins start to dip or there is a clear disparity between yourself and a competitor, the parts and partners involved in your supply chain should be assessed to figure out where you can save.
Price of Goods:
Sometimes it can be as simple as increasing the prices of your products or services which will see a promising increase in both your revenue and eventually your gross profit margin. Whenever price increases are necessary, it can be worthwhile to maintain good faith in your customer base by explaining the reasons for the rises.
A product price increase actually ties into the other metrics of your gross margin quite significantly. It reflects on many factors such as labour costs or supply chain breakdowns, and can help you gauge where you stand in comparison to your competition. If they are severely undercutting you while maintaining a positive gross profit margin, this is a detail that needs to be focused on.
Customer Retention:
One great metric that not only plays an important role in many industries’ gross margins, but also indicates whether a company is ‘doing it right’, is customer retention. If your main purchaser base is returning to your products and services it is a good indicator that the other parts of your gross profit margin equation are working effectively.
It quickly becomes clear just how many important factors can be analysed from the few metrics that we use to figure out the gross margin percentage, demonstrating how useful it can be for any business owner who is serious about expanding their brand name into the future.
Final Thoughts
Understanding how to effectively analyse and capitalise upon the results of the gross profit margin can be the difference between a company’s rise, fall, or utter stagnation. It demonstrably serves as a touch point whereby business owners can scrutinise the efficiency of their operations, and get to grips with what is or is not working, but more importantly, why.
By focusing on the key variables we have covered across the course of this post, a business can actively keep working towards improving its gross profit margin. Remember, a positive gross profit margin not only represents sustainable financial health, but it also reveals opportunities for businesses to improve their operating efficiency.
Incorporating Pulse for Financial Analysis
Pulse can offer your company an array of invaluable financial insights, whether you are that woolly hat-making entrepreneur or the firmly established hotel owner. If you are already utilising Fintech, namely Open Banking or Open Accounting, Pulse can show you all the numbers that will make your gross profit margin go up every year once you’ve given us the all-clear.
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