Gross profit margin is one of the most essential metrics you can use to assess your business’s financial success. Not only does it serve as an indicator of long-term viability and profitability overall. But it also allows you to assess the efficiency of your production processes when compared to those of your key competitors.
In a nutshell, a business’s gross profit margin (GPM) indicates how much money an organization has made after paying its costs of goods sold. These are the direct costs associated with operating a business. GPM is usually expressed as a percentage of your net sales.
Ideally, your company’s gross profit margin should reach a level where your revenues consistently cover your production expenses and cost of goods sold. Any company that doesn’t reach this level needs to rapidly adjust their strategy to avoid running at a loss and risking its future!
In this comprehensive guide, we’ll explore the topic of business profitability in more depth. To ensure you can gauge your GPM’s impacts on your operations, we’ll provide definitions, functions, metrics, and other tools you can use to your advantage.
What are Sales Revenues?
A business’s gross profit margin is, in essence, a percentage of its sales revenues after certain costs have been deducted. It’s important to understand exactly what your sales revenues are in order to accurately calculate your GPM.
Sales revenue, also known as net sales, is the amount of money your business earns from selling products and services to its customers. It doesn’t include returned merchandise or the proceeds of any discounts given to your buyers. Net sales are often expressed either as credit sales or cash sales, with eCommerce businesses working primarily with credit sales.
Gross Profit Margin Definition
Gross profit margin (GPM) is a metric used across dozens of industries to assess the financial health of a business. Business analysts use GPM calculations to determine how much money is left over from sales revenues after the cost of goods sold (COGS) gets subtracted.
Gross profit margins may also be referred to as gross margin ratios and are most often expressed as a percentage of total sales. This percentage of your total sales will show how much profit you’ve made before the deduction of costs relating to administrative processes, selling, marketing campaigns, and general expenses. Once these costs get deducted, you’ll be left with your business’s net profit margin.
Do you need help maximizing your profitability?
Contact Growth Hackers
How to Calculate Your Business’s GPM
Business analysts use a universal formula to calculate a business’s gross profit margin. You can calculate your own company’s GPM using the same formula:
(Net Sales – Cost of Goods Sold)/Net Sales = Gross Profit Margin
If used correctly, this formula will produce your gross profit margin as an accurate percentage of your total sales.
Why It’s Important to Calculate Gross Profit Margin
Analysts across industries use gross profit margin as a metric to compare a specific organization’s business model with those of its closest competitors.
Let’s say, for instance, that your business and your nearest competitor in your niche both produce sports equipment with similar characteristics and quality levels. If your competitor finds a way to produce its products at a lower cost, it will secure a higher gross profit margin by reducing its COGS.
This means that your competitor would gain a leading edge in your market. In turn, this could jeopardize your sales and profitability in the long run. Calculating and knowing your GPM is an effective way of highlighting where your profits are falling short. And then using the right strategies to keep your business competitive.
Understanding Good Gross Profit Margins
Once you’ve calculated your business’s gross profit margin using the formula above, you want to compare your GPM to other businesses in your sector or industry. It’s important to bear in mind that GPM is a relative number. This means that you cannot accurately compare it across different industries. Every industry has a varied gross profit margin average. Therefore, you should always measure your own margins against competitors in your specific niche.
For example, technology and finance businesses often report gross profit margins of 90% or higher, while other industries can vary significantly. According to data collected by New York University, the advertising industry has an average GPM of 26.2%. Other stats reveal the following margins:
- 53.04% for apparel
- 99.83% for banks
- 36.78% for healthcare
- 28.92% for real estate
General retail industries report GPMs of around 24.32% on average, while most online retailers report GPMs of around 41.54%.
GPM and Seasonality
Some industries also experience a high degree of seasonality. This seasonality can affect their gross profit margins from period to period. As an example, retailers and entertainment businesses will typically earn far higher revenues during the holiday season in December. However, other industries like healthcare and banking, won’t necessarily experience a similar spike.
Financial experts recommend that business leaders compare their fourth-quarter profit margins from the previous year with those of their closest competitors. This can help them to gain a more accurate overview of GPM, especially if they operate in a seasonal industry.
How a Low Profit Margin Could Impact Your Business
If you compare your GPM to your closest rivals in your industry and find that your gross profit margin is low in comparison, it’s important to take action. A low profit margin can indicate an excessively high cost of goods sold. This often stems from low sale prices, unfavorable purchasing practices, tight industry competition, or sub-optimal sales and promotion approaches.
According to Your Business at AZCentral, the most significant disadvantage of having a low profit margin is that your operational efficiency will suffer. When your operational efficiency suffers, your sales, marketing, advertising, customer service, logistics, and other key processes will all be negatively impacted. This leaves you with a less efficient—and increasingly less profitable—venture.
Take control of your gross profit margin today!
How to Increase Your Gross Profit Margin
There are two key approaches through which you can increase your business’s gross profit margins. You can increase your prices. Or you can reduce your cost of goods sold.
The right solution will depend on your business and your target markets. But both of the key approaches come with risks. So, it’s important to make an informed decision.
If you choose to raise your prices, you’ll most likely pass those expenses on to your customers or clients. Price increases are best implemented in increments or in alignment with the strategies of your closest competitors. Unfortunately, increasing your prices does carry the risk of alienating your loyal customers. Plus, it may drive prospects to seek out more cost-effective options.
Reducing your COGS is often the safer choice, although it can also be more challenging to achieve. Depending on the nature of your business, there are a few options you can choose.
You can:
- Reduce your cost of goods sold by automating your processes
- Negotiate discounts with your suppliers
- Find more cost-effective suppliers and vendors
- Design economies of scale
- Buy raw materials and products in bulk at discounted rates
- Substitute expensive materials with cheaper ones of similar quality.
Additionally, some businesses choose to move their manufacturing processes offshore to more affordable countries. Or they eliminate poor-performing products and focus on their best sellers instead.
When you know how to calculate profit margins there are multiple options that you can explore to increase them. You can even combine a few methods for the best effect if they suit your business.
What Are Profitability Ratios?
Profitability ratios are metrics that business analysts, leaders, and investors use to evaluate a company’s ability to generate profits. These ratios allow you to compare your profitability relative to your revenues, the assets on your balance sheet, the costs of operation, and your shareholder equity within a given period of time.
Ultimately, these ratios show how effectively your business is using its assets to generate profits and add value for its shareholders.
Businesses of all sizes, industries, and locations seek out higher profitability ratios. This means that their companies are performing well and generating strong profits, revenues, and cash flow. Profitability ratios, which include gross profit margins, are also useful when comparing your profits to those of other similar companies in your industry during a certain time frame.
According to the Corporate Finance Institute, you can categorize profitability ratios into two main groups: margin ratios and return ratios.
The margin ratios include gross profit margin, net profit margin, EBITDA, operating profits and cash flow.
The return ratios include return on equity, return on invested capital, and return on assets.
Gross Profit Margins in Summary
Profitability ratios like gross profit margin can highlight how effectively your business is being managed and operated. These metrics are used universally by investors and analysts to determine whether or not a business is profitable—and whether or not it’s a solid investment for future buyers.
The stronger your GPM and other profitability ratios, the more revenues you will be able to generate while maintaining low costs, thereby allowing you to improve your profit margins even further.
Use this comprehensive guide and the GPM formula above to assess your company’s profitability and performance.
Growth Hackers is recognized as one of the top accounting marketing agencies helping businesses from all over the world grow. There is no fluff with Growth Hackers. We help entrepreneurs and business owners maximize their profitability with gross profit margin optimization strategies, increase their productivity, generate qualified leads, optimize their conversion rate, gather and analyze data analytics, acquire and retain users and increase sales. We go further than brand awareness and exposure. We make sure that the strategies we implement move the needle so your business grow, strive and succeed. If you too want your business to reach new heights, contact GrowthHackers today so we can discuss about your brand and create a custom growth plan for you. You’re just one click away to skyrocket your business.
