Let’s start by stating the obvious: the goal of any business, no matter its size, is to make a profit. To assess the cost-efficiency of a given product, the gross margin is the reference indicator that needs to be used. And as a retailer or SMB owner, it is crucial to monitor your profit margins regularly as it allows an efficient allocation of resources.
Your profit margins enable you to determine the most profitable areas of your business and how to grow them. A thorough understanding of this metric ensures proactive leadership and fact-based decision-making.
This article will explain gross profit margin, how to calculate it, and tips to improve your gross profit margin. Here are the critical points we’ll cover in this blog?
Table of Contents
- What is the gross profit margin?
- How to calculate gross profit?
- What is the gross profit margin formula?
- Example of gross profit margin formula
- Why is it important to calculate gross margin?
- What is a good gross profit margin?
- Tips to improve your profit margin
- Conclusion on how to calculate a gross profit margin: what to take away?
What Is The Gross Profit Margin?
The gross margin is the difference between the selling price and the total cost of goods and services sold, excluding taxes. It is used to determine whether or not a particular activity is likely to generate a profit.
For example, in the context of a pricing policy, setting a gross margin per product will be useful and allow for negotiating purchasing costs with suppliers. The gross profit margin is used to determine the efficiency of a product sold by the company or of more than one product.
A product may be designed and sold more efficiently by one company than by another. For each product sold by the company, the gross profit margin can be calculated, provided that the company differentiates the direct production costs of each product from the others. The direct costs of production of its products represent the cost of goods sold (COGS), which is included in a company’s income statement.
See related: What Are Prime Costs?
You need two variables of gross profit to calculate gross profit margin: the net sales or revenue and the cost of goods or services sold. The gross margin is calculated by subtracting the cost of goods sold from total revenue.
Net sales are the total revenues generated by the company, excluding sales returns, rebates, and discounts. This metric is used by analysts when making decisions about the company’s growth or the company’s revenue. Net sales are derived from gross sales and are most important when analyzing a company’s sales quality.
Cost of Goods Sold
The cost of goods sold is the direct cost of inventory sold by a company in a given period. It includes all costs directly attributed to goods or services sold in a given week, month, or year. However, it excludes all indirect or fixed expenses such as overhead and marketing; it is simply the cost of purchasing or manufacturing the inventory sold in a given period. Below are some examples of COGS.
- Required parts for raw materials or manufacturing
- Labor charges directly associated with the production
- Shipping costs
- Customer support time
- Equipment costs related to production
- Manufacturing facilities
Cost of goods sold (COGS) is calculated by taking the inventory value at the beginning of the reporting period, adding the cost of any new inventory purchased during the reporting period, and subtracting the value of inventory held at the end of the period.
The gross profit ratio shows the percentage of sales that a company retains after covering all direct costs associated with its operation. Here is the formula:
The formula of the gross profit is: Gross Profit = ( Net Sales – Cost of Goods Sold )
Gross Profit Margin = (( Net Sales – Cost of Goods Sold) / Net Sales) x 100
As an example of gross margin, a t-shirt retailer sells a shirt for $100. Let’s assume that the production cost of the shirt is $25. This yields a profit of $75 for the retailer. This equals a margin of 75%. Let’s do the math for a better understanding:
Net Sales of the product: 100
Total production cost: 25
Gross profit: 100-25= 75
Gross profit margin: 75/100 x 100= 75%
The gross margin is a strategic performance indicator. Indeed, a high gross margin allows certain flexibility in the market. It can represent a real competitive advantage, allowing you to lower your selling price. In the event of an increase in costs, it is also an excellent way to ensure profitability.
It allows you to compare the different products and quickly know which one you can make the most margin from. The higher this rate is, i.e., closer to 100, the more profitable your product is.
A thorough understanding of your business margins enables you to make immediate decisions to foster growth and resilience in your business. For example, a spike in the price of a product may reveal a new trend that warrants more investment, while a downturn may indicate an increase in expenses, leading you to analyze your cash flow and make cuts if necessary.
Understanding your gross margin is necessary because it allows you to do the following:
- Estimate the profitability of a product or service
- Compare products and services of the same category
- Set the price of a product or service
- Lower the price of a product in order to gain market share
- Determine the bargaining power of a business enterprise
Of course, when you have a high-profit margin, it usually means that you have made a significant financial gain on a product. On the other hand, a low-profit margin means that your selling price is hardly higher than the cost. However, you should know that margins vary from industry to industry and also by company size. Some businesses are remarkably successful with tiny profit margins, while others with high margins struggle to turn a true profit. The difference is often a result of the indirect costs that are not calculated in the profit margin.
To illustrate, one study showed that the average gross profit margin was under 10% for car and truck manufacturers. However, in a survey of more than 130,000 retailers, the profit margin was 53% in retail.
As a retailer or SMB owner willing to grow your business, you should never lose sight of your profits. Profits help you sustain your business and enable growth. If you’re struggling with your gross profit margin, here are some tips to improve your sales figures:
1. Identify what is not working to improve your gross profit margin
It is essential to take an objective look at your business to see what is not working if you are not satisfied with your profit growth or margin. To find out what is wrong, you can look into your expense reports, your staff operation, your inventory management, your POS system, etc., and find out where you are lacking and correct it.
Is your retail loyalty program not compelling enough? Have you stopped looking for ways to attract new customers? Is the customer experience within your company lacking? These are just a few of the many areas you can examine and improve to create a better plan for moving forward and increasing your profits.
2. Outsource when possible
Poor payroll management in your business can harm your profit margin. Many small business owners have difficulty knowing the right number of employees for their business needs. Having too few employees will not allow you to take care of your customer base properly. If you have too many, on the other hand, you’ll have a high payroll and inactive employees.
The most effective way to address this is to outsource some business tasks to contract workers or freelancers. You can use them when the demand is high, and you don’t have to pay them when they are not needed. There are also some great labor management software options available to make this more streamlined and efficient.
3. Use the right technology tool to boost your profit margin
With the advent of the COVID-19 pandemic, the role of technology tools in businesses has never been more critical. Having an elite point of sale system that can manage specific tasks is essential to the smooth operation of your business. An excellent gross profit margin depends on a sound inventory management system and a good marketing strategy that can help you boost your sales.
Our retail POS system, KORONA POS, is a cloud-based system particularly designed with each of these crucial features. KORONA POS enables you to optimize your time and have a complete overview of your business. Some of the features our POS system offers include:
- Individual employee reporting
- Loyalty program integration options
- Quickbooks compatibility
- Email marketing and CRM features
- Remote POS access
- Automated ordering features
- Stock reports and inventory metrics
- Variable access levels
- Payroll & time tracking assistance
- EMV and mobile payment integration
- Tip processing and reporting
- Discount and promotional pricing
Calculating your gross profit margins allows you to better organize your cash flow and ensure that there is always enough money to pay your suppliers, staff, and expenses on time.
Also, for a good profit margin, you need to equip yourself with the best tool that’ll help you make strategic decisions for your business when you need it. That’s what KORONA POS is built for. You can try it now for free by clicking on the button below.