How is the gross profit margin calculated?

How is the gross profit margin calculated?

Gross profit margin

The gross profit margin is a key metric for sales teams. Through it, it is possible to evaluate the efficiency of business operations and identify red flags.

With a simple formula , you can evaluate the financial health of your company and compare the results with those of the competition. This will give you a realistic picture of your position in the market and allow you to make the necessary changes to stay ahead of the industry .

In this article, you will find:

  • What is the gross profit margin?
  • Advantages of the gross profit margin
  • Disadvantages of gross profit margin
  • How is the gross profit margin calculated?
  • Percentage gross profit margin formula
  • Net profit margin formula
  • What does high gross profit margin mean?
  • What does low gross profit margin mean?

What is the gross profit margin?

The gross profit margin is an analytic metric used to assess the financial health of a company. It reveals the percentage of income obtained in relation to the costs necessary to generate it.

Advantages of the gross profit margin

Gross profit margin is a very simple metric , indicating profitability and helping companies track performance over time. It can be used as a guide for optimizing operations and pricing products and services , as well as serving as a comparison with similar organizations in the industry .

Disadvantages of gross profit margin

Before learning how gross profit margin is calculated, keep in mind that this metric has limitations . Although it presents a diagnosis of the financial health of your company, the gross profit margin cannot tell you precisely what is right and what is wrong. Therefore, to obtain complete and detailed information, you must analyze it along with other metrics.

How is the gross profit margin calculated?

Now that you know what gross profit margin is and what the importance of this metric is, the next step is to learn how it is calculated. Take a look at the formula!

Gross profit margin = total revenue – cost of products or services

Let’s see what each part of the gross profit margin formula means:

  • Total income: The amount of money that is earned from the sale of products and services during a specified period of time.
  • Cost of products or services: Direct or indirect expenses involved in the manufacturing and marketing process of products and services. For example, raw materials, storage, transportation, packaging, insurance, advertising, among other costs.

Gross profit margin calculation example

Imagine that you have a bakery and you sold 100 chocolate cakes in a month, generating an income of 4 thousand dollars. To produce these desserts, you spent 2,000 on ingredients and packaging. In this case, the gross profit margin calculation will look like this:

  • Gross profit margin = 4,000 – 2,000 = $ 2,000

That means for every 100 chocolate cakes sold, you make $ 2,000 in profit. Simple, right?

Percentage gross profit margin

Do you prefer to work with percentages? No problem! There is a formula to calculate the gross profit margin percentage:

Percentage gross margin = gross profit ÷ total revenue x 100

Let’s go back to the bakery example to put this formula into practice. In the above calculation, we found that the gross profit was $ 2,000, right? So we will have:

  • Percentage gross margin = 2000 ÷ 4000 x 100 = 50%

This means you have a 50% percent gross margin for every 100 chocolate cakes sold. It is a great number!

Net profit margin

Net profit margin is calculated by deducting your fixed and variable costs from gross profit. Here is the formula:

Net profit = gross profit – fixed and variable expenses

According to our example, the gross profit is $ 2,000. It remains for us to discover fixed and variable expenses. If, in addition to the ingredients and packaging costs that we already know ($ 2,000), you include the bakery rent and the pastry chef’s salary, we could reach $ 5,000.

In this case, the calculation of net income would look like this:

  • Net profit = 2,000 – 5,000 = -3,000 dollars

It looks like we are losing money!

This negative number means that, in general, your costs are higher than your income. This can happen when product prices are too low or operating costs are too high. Either way, there is an imbalance that needs to be examined more closely.

Do you doubt that the prices of your products are adequate for the market? We recommend you read: How to calculate the price of a product in 4 steps .

What does high gross profit margin mean?

A good gross profit margin depends on the industry in which you operate. In general, 5% is low, 10% is average, and 20% can be considered good.

According to an academic study , educational and cultural services have the highest gross profit margins, reaching 63% each. The data also shows that companies in the hospitality, agriculture and retail sectors do not exceed 40%. Perhaps most surprising is the construction sector, which reaches a paltry 26%.

As you can see, all of these industries have extremely high gross profit margin, but when compared to each other, they show large variations. This is because the costs of each business are different, as well as government regulations, which affect taxes and the price of products or services.

Whatever number you get in your calculation, the important thing is to record it to compare it with previous and future periods. This will help you evaluate the progress of your business or act as a warning sign that something is wrong.

What does low gross profit margin mean?

Once again, it is worth emphasizing that the gross profit margin varies by industry. Therefore, the analysis parameters will be different if you operate in the technology sector or in the financial sector, for example.

If you already have this in mind and have concluded that your percentage is low compared to the market, this may be a red flag. Here’s why: If your gross profit margin measures the financial health of your business, a low number means that you are not producing or marketing your products as efficiently as possible.

And there are several reasons for this, but we would like to highlight three.

1. You sell little (Quantity)

If you’re selling low, your gross profit margin may be underperforming. More than a negative impact on an analytical metric, this is a warning for your business strategy : staying at this rate may mean not being able to cover the operational and administrative expenses of your business

2. You sell cheap (Price)

You may sell a large number of units of products or services, but the price is below what is necessary to cover costs and ensure a positive gross profit margin. Eye!

3. You sell badly (Efficiency)

If products sell out easily and the price is right for the market, maybe the problem is in the sales cycle . If it’s not as efficient as it could be, you may be taking too long to receive the revenue related to your efforts, resulting in a low gross profit margin in the periods analyzed.

Sell ​​more and better with Zendesk

Gross profit margin is just one of the metrics you should monitor. To make sure your sales team is on track, there are dozens of indicators that you should regularly monitor and compare with other time frames. Only then can you make smart strategic decisions, based on data and not intuition .

However, manually recording all this information is backbreaking work. Not to mention the possibility of human error, such as duplicate, inconsistent, or decontextualized data. And that’s not a desirable thing, is it?