To gauge the profitability of a business, understanding what gross profit margin represents is critical. One of several commonly used profitability ratios, the gross profit margin is relied upon to measure how much revenue a business earns for each dollar of sales created. Also known as the ‘return on sales’ ratio, the gross profit ratio considers how the cost of goods sold impacts the revenue remaining from any sales generated over a period.
Gross profit margin helps a business understand how much cost of goods sold cuts into revenues received from sales. If sales are high but gross profits are slim, this may indicate the cost of goods sold or the cost of services rendered is substantial. A business may seek to cut manufacturing or other costs to reduce the cost of goods sold and increase its gross profit margin.
This article will illustrate the gross profit margin formula, how to calculate gross profit margin step by step, and provide further examples on how gross profit margin can be utilized in various scenarios.
Formula
Gross profit margin is calculated by subtracting the cost of goods sold (COGS) from revenue and then dividing that product by revenue. For services, replace COGS with the cost of services rendered. Gross profit margin is expressed as a percentage, so multiply the product by 100.
Calculation Step by Step
- Determine revenue and cost of goods sold for a given time period.
- Subtract the cost of goods sold from revenue and then divide by revenue.
- Multiply the product obtained from division by 100.
Following these steps will yield the gross profit margin expressed as a percentage. This percentage represents the amount of money remaining from the sale of goods or services.
Example
A watchmaker needs to determine its gross profit margin for the first quarter of 2021.
Based on their operations, the watch-maker calculated the following values:
Sales Revenue: $100,000
Cost of Goods Sold: $50,000
First, the business owner will subtract the cost of goods sold from revenue for the period:
Remaining Revenue = Revenue – Cost of Goods Sold
Remaining Revenue = $100,000 – $50,000
Remaining Revenue = $50,000
Next, the business owner will divide the remaining revenue by the amount of revenue generated from sales:
Gross Profit Ratio = Remaining RevenueRevenue
Gross Profit Ratio = $50,000$100,000
Gross Profit Ratio = 0.5
Finally, the business owner will now multiply the gross profit ratio by 100 to express gross profit margin as a percentage of sales generated for the period:
Gross Profit Margin = Gross Profit Ratio x 100
Gross Profit Margin = (0.5) x 100
Gross Profit Margin = 50%
Here we can see that 50% of revenue remains after accounting for the cost of goods sold. This allows the owner of the watch-making business to determine that for every dollar of sales generated, 50 cents remains as gross profit.
Tips for Calculating Net Income
Tip Number 1:
Gross profit margin can be applied to individual lines of products. If a business offers multiple types of products but wants to know the gross profit margin for a specific product line, the formula can be applied to reflect this. Simply calculate the revenue and cost of goods sold for that specific product line, and follow the steps listed above to solve for gross profit margin. This assists businesses in determining if certain products have lower margins compared to others.
Tip Number 2:
Remember that costs like administrative overhead costs, taxes, interest, or other costs are not represented in the gross profit margin. The costs present in the gross profit margin formula only represent the cost of goods sold or the cost of services rendered. Other costs can be deducted from the gross profit margin, but this will result in the net profit margin.
Tip Number 3:
When determining the amount of revenue and cost of goods sold to include in the gross profit margin formula, make sure to account for any returns or allowances made over the period. For example, some items purchased by customers are later discovered to be defective or inoperable. Customers will often attempt to return these items for a refund. Deduct any such returns or allowances made to customers from revenue and cost of goods sold, as these events generate no profit for the business.
Calculating Gross Profit Margin In Excel
Gross profit margin can be effectively and accurately calculated using Microsoft Excel. Since revenue and cost of goods sold or cost of services rendered is normally found in a company’s financial statements, such statements are commonly converted into Microsoft Excel files for faster calculations.
To arrange a Microsoft Excel gross profit margin calculator, follow these simple steps.
For this example, we will calculate the gross profit margin of the watch-maker business for the first quarter of 2021.
We can observe that for the first quarter, the watch-maker generated sales revenue of $100,000. Additionally, the cost of goods sold totaled $50,000 for goods sold over the period. Expenses such as utilities or taxes do not need to be considered for our purposes.
To calculate revenue remaining after the cost of goods sold are deducted, insert the following formula into the remaining revenue cell of B6 (make sure to put a “-“ in front of B4):
=SUM(B3,-B4)
After solving for remaining revenue, calculate gross profit margin by inserting the following formula into cell B8. This formula divides remaining revenue by sales revenue:
=IMDIV(B6,B3)
Finally, multiply the gross profit ratio by 100 to solve for gross profit margin. Complete this by inserting the following formula into cell B9:
=(B8)*(1)
The result from the gross profit margin calculator will be a gross profit margin of 50%.
What Is A Good Gross Profit Margin?
A good profit margin varies by industry, as expectations, competition, and even regulations differ between each.
For example, in the restaurant industry, a healthy gross profit margin is 10%. The gross profit margin in this industry is low due to consumer expectations and active competition between numerous restaurants. In the defense industry, however, a reasonable gross profit margin is 15%, as mandated by government guidance.
Across all industries in the United States, the average gross profit margin hovers around 36.22% according to a report compiled by New York University.
While the business owner should compare their gross profit margin to the industry average, they should ultimately determine what a good gross profit margin is for their specific business. A gross profit margin needs to exist to cover other administrative costs but can’t be too exorbitantly high as to drive away demand.
Gross Profit Margin Takeaways
Gross profit margin is the amount of revenue remaining after deducting the cost of goods sold, represented as a percentage. As one of the most important profitability ratios, the gross profit margin can be used to determine if the cost of goods sold is too high. Gross profit margin can also be used to determine net profit margin by deducting costs other than the cost of goods sold.
When determining what a good gross profit margin for your business is, compare it to the industry average and consider how your gross profits are used to cover additional costs, like administrative expenses, taxes, or interest.
