When it comes to running and optimizing your small business, there are many different metrics you can analyze to assess your business's overall financial health - including gross profit margin, which is a measure of a company's profit on goods or services it sells.
Part of being able to analyze metrics associated with your business's health is having organized data and financial information about your company. Often, products like Skynova's accounting software help make the task of collecting and tracking financial information much easier.
In this article, we will discuss what information you need to calculate gross profit margin, how to calculate it, and what it means in small business accounting.
What Is Gross Profit Margin?
Gross profit margin is a measure of how much profit you make off the goods or services you sell after subtracting the cost of goods sold (COGS) from the total revenue. It is a unitless number and may be given as a decimal between 0 and 1 or as a percentage.
The total sales revenue is the total amount of money received for the sale of the product or service. The COGS is simply any direct costs associated with the materials and production of the goods.
How Do You Calculate Gross Profit Margin?
Calculating your business's gross profit margin (sometimes called the gross profit margin ratio or the gross margin ratio) doesn't have to be complicated. We will walk you through it step by step, starting with the formula and then breaking down each part.
The following gross profit margin formula gives a value between 0 and 1:
The formula can also be written to present the gross profit margin as a percentage:
Step 1: Determine Total Revenue
Before determining total revenue, make sure you know what numbers you're working with. For example, are you determining the gross profit margin for all products or services you sell or just for one product in particular? What time period are you calculating it over?
Make sure the answers to those questions are established so you can be sure that you are collecting the right numbers to do the calculation. Gather the necessary paperwork or records and start by finding the total revenue for the particular product or service over the specified time period.
To get the total amount of revenue, you simply need to add up every dollar of revenue recorded on the associated income statement for the sale of the product or service in question. The revenue in question should be from net sales (the total sales minus refunds or returns). If you don't have a neat record of your numbers (this is one of the places accounting software can come in handy), the total revenue should be the selling price of the item or service multiplied by the number sold (minus any returns).
For example, if Marco wanted to calculate the gross profit margin on widgets sold last month, he would find his sales records or income statement and add together the total amount each widget sold for. If he finds that 36 widgets were sold at a price of $45 each with no returns, his total revenue from widget sales last month is 36 x 45 = $1,620.
Step 2: Add Up the Cost of Goods Sold
The cost of goods sold (COGS) includes any production costs incurred in the making of the goods in question. This includes raw materials, direct labor, and anything else that was paid out in producing the items.
This information may be found on a balance sheet, income statement, or in receipts from transactions. When adding up the cost of goods sold, be sure that you only include costs directly related to the specific item and time period for which you are computing the gross margin. Don't include things like operating expenses or overhead.
Continuing our earlier example, suppose the 36 widgets had the following costs associated with their production:
- Materials: $400
- Direct labor: $500
- Other: $250
Then, the COGS is the sum of these numbers: $1,150.
Note that for some businesses, especially those that specialize in providing services such as writing or coding, the COGS may be low to none since there are no material costs.
Step 3: Calculate the Gross Profit Margin Percentage
If you have your total revenue, COGS for the product(s), and time period in question, you are ready to input them into the gross margin percentage formula. Here, we will do so with the numbers for the fictitious widgets described earlier:
- Total revenue = $1,620
- COGS = $1,150
These are then plugged into the formula:
To get the correct answer, perform the calculations in the correct order as follows:
- Take the difference between total revenue and COGS: $1,620 - $1,150 = $470
- Divide the difference by the total revenue: $470/$1,620 = 0.29
- Multiply the result by 100 to make it a percentage: 0.29*100 = 29%
Thus, the gross profit margin percentage for widgets sold last month is 29%. What this means is that 29% of the revenue is gross profit, while the other 71% of the revenue was eaten up by the cost of creating the product. As such, the gross profit margin serves as a measure of the profitability of the product in question and gives a sense of the size of the pricing markup.
What Is a Good Gross Profit Margin?
Interpreting what financial ratios can tell you is challenging even for the best of us. However, being able to accurately interpret and assess these metrics can help your business's bottom line. When it comes to the gross profit margin, what constitutes a good or bad number can be relative and vary by industry, company age, and more.
Consider someone who sells services, not products. They would likely have much higher gross margins because their COGS is near 0. When determining if your margin numbers are good or bad, you should compare them to the gross margins of the other products that you sell, the gross margins of the same product in the past, or the gross margins that other companies might be seeing on similar products.
As mentioned in the previous section, the gross margin tells you something about the profitability of a product. As a general rule, higher profit margins are better because they mean you make more money off a particular product relative to the amount you initially invested.
Suppose, for example, your company sells three products with gross profit margins as follows:
Product A: 35%
Product B: 22%
Product C: 37%
The company's management notices that Product B appears to be underperforming the other two products. Depending on their resources and the situation, they may choose to increase the markup on it, try to source cheaper parts to make the product with, or divert their resources to the manufacturing of more profitable products and discontinue Product B.
Let Skynova Help You Manage Your Small Business Accounting
If you are a small business owner, startup founder, or independent contractor, keeping track of your business transactions and monitoring your cash flow should be a high priority. This is where Skynova can help.
Skynova has an assortment of templates and products designed just for small business owners like yourself. Not only can we help you create personalized and professional invoices, purchase orders, or packing slips, but we also offer accounting software to streamline your bookkeeping and invoicing.
Visit Skynova today and find products that will simplify your small business accounting process.