GROSS PROFIT MARGIN: WHAT IT IS, CALCULATION, EXAMPLES - DUDAS - 2025

The gross margin is a financial indicator used to assess the financial health and business model of a company, revealing the proportion of money left from income after accounting for the cost of goods sold. It can be calculated by dividing gross profit by total revenue.

Gross profit margin is a key measure of profitability against which investors and analysts compare similar companies, and businesses, to the broader industry.

Source: pixabay.com

It is an indicator of the financial success and viability of a particular product or service. The higher the percentage, the more money the company will keep on every dollar of sales to pay its other costs and obligations.

Small business owners are always looking to improve their gross profit margins. In other words, they want to reduce the cost of merchandise sold while increasing sales revenue.

What does it consist of?

There are several levels of profitability that analysts monitor to evaluate a company's performance. For example, gross profit, operating profit, and net profit.

Each level provides information on the profitability of a company. Gross profit, the first level of profitability, tells analysts how good a company is at creating a product or providing a service compared to its competitors.

Gross profit margin, calculated as gross profit divided by revenue, allows analysts to compare business models with competitors, with a quantifiable metric.

How to increase gross profit margin?

One way to do this is by increasing the price of the product. However, care must be taken when doing this. If prices are raised too much, sales may fall.

To successfully raise prices, the economic environment, competition, supply and demand for the product must be measured, along with any useful information that can be gathered from the customer base, such as income, spending habits, and credit preferences.

The cost of manufacturing the product can also be reduced. This is as complicated as increasing the price of the product.

The product can be made more efficiently. This could imply lower labor costs, which could require layoffs or other restrictions that affect the goodwill of employees, and could affect product quality.

Finally, manufacturing costs can be lowered with respect to materials. It is possible to look for a supplier of materials that offers them at a cheaper price. You can also try negotiating volume discounts with your current vendor.

When looking for a supplier that offers materials at a cheaper price, you should never lose sight of quality.

Managing gross profit

Without adequate gross profit, a business cannot pay its operating expenses. In general, a company's gross profit margin should be stable, unless there are changes in the company's business model.

For example, when companies automate certain functions in the supply chain, the initial investment can be high. However, the cost of the merchandise sold will be much lower due to the lower cost of labor.

Changes in industry regulation or even a company's pricing strategy can also generate gross profit.

How is it calculated?

Gross profit is used to calculate gross profit margin. This is calculated simply by dividing gross profit by total income:

Gross profit margin = Gross profit / Total income.

If the gross profit is determined by subtracting the cost of the merchandise sold from the total income, then the following formula can also be had:

Gross profit margin = (Cost of merchandise sold - Total revenue) / Total revenue.

Calculating the gross profit margin allows you to compare similar companies with each other and with the wider industry to determine their relative profitability.

Gross profit margins vary widely by industry. For example, food and beverage stores and construction companies have extremely low gross profit margins. On the other hand, the healthcare and banking industries enjoy much larger margins.

Examples

The most efficient or higher priced companies see higher profit margins. For example, if you have two companies that produce items and one of them can make these items for a fifth of the cost in the same amount of time, that company has the advantage in the market.

The company has discovered a way to cut the costs of merchandise sold five times more than its competitor.

To make up for the loss in gross profit, the competitor will try to offset it by doubling the price of its product. This should increase your income.

Unfortunately, as the sale price increased, the demand decreased, because customers did not want to pay double for the product. The competitor then lost gross profit and market share.

XYZ Company

Suppose company XYZ earns $ 20 million in revenue from the production of items. On the other hand, it incurs $ 10 million in expenses related to the cost of merchandise sold.

XYZ's gross profit is $ 20 million minus $ 10 million. You can calculate the gross profit margin as the gross profit of $ 10 million divided by $ 20 million, which is 0.50 or 50%. This means that XYZ earns 50 cents on the dollar in gross margin.

ABC Clothing

Let's look at ABC Clothing's gross profit as an example to calculate gross profit margin.

In year 1, sales were $ 1 million and gross profit was $ 250,000, resulting in a 25% gross profit margin ($ 250,000 / $ 1 million).

In year 2, sales were $ 1.5 million and gross profit was $ 450,000, resulting in a 30% gross profit margin ($ 450,000 / $ 1.5 million).

Clearly, ABC Clothing made not only more money from gross profit in year 2, but also a higher gross profit margin.

The company raised prices, or lowered supplier material costs, or found a way to produce its product more efficiently. This generally means fewer man hours per product manufactured.

ABC Clothing did a better job in year 2 managing their brand on the clothing products they made.

References

1. Entrepreneur (2013). How to Calculate Gross Profit. Taken from: entrepreneur.com.
2. Investopedia (2018). Gross Profit Margin. Taken from: investopedia.com.
3. Investing Answers (2018). Gross Profit Margin. Taken from: investinganswers.com.
4. Rosemary Peavler (2018). The Meaning and Use of Gross Profit Margin. The Balance Small Business. Taken from: thebalancesmb.com.
5. My Accounting Course (2018). Gross Profit Margin. Taken from: myaccountingcourse.com.