As a business owner, you’ll already know there are a whole host of ways to measure profitability, but did you know that gross profit margin is one of the best metrics we use to highlight strategies that improve your future profits?
Understanding gross profit margin is a critical step to assessing your business and then planning an effective strategy for growth.
If you’re unsure how to work out gross profit, let alone how to work out gross profit margin, don’t worry! We’re going to run you through everything you need to know in this article.
Before we explore how gross profit margin is so crucial to business strategy, let’s break down exactly what it is, how it differs from gross profit and how to work out gross profit margin.
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What is Gross Profit?
Gross profit is the amount left after subtracting the cost of goods sold (COGS) from your total revenue. COGS would include things like raw materials, labour costs, and manufacturing. These are costs related directly to the production or provision of products or services.
Gross profit tells you how much money your business has made before accounting for overheads like rent, wages, and other operating expenses.
Gross profit formula – how to get gross profit
Now you know what gross profit is, let’s look at how to work out gross profit in your business.
Simply take your revenue figure for your selected period of time, such as your most recent quarter, and subtract all direct costs related to producing products or providing services.
Gross Profit = Total Revenue – Cost of Goods Sold (COGS)
For example, if your business generates £500,000 in revenue and your direct costs (COGS) are £250,000, your gross profit would be £250,000.
While gross profit gives a clear picture of your business’s total earnings after production costs, it doesn’t show efficiency. This is where gross margin comes in.
What is Gross Profit Margin?
Your gross profit margin (often called gross margin) represents the percentage of revenue left after you have accounted for direct costs.
Instead of an absolute figure like gross profit, it shows how efficiently your business turns sales into profit before other expenses come into play. As a general rule, the higher this percentage, the healthier your business, so it’s a key factor in determining and managing your business’ health, as well as your business growth strategy.
How to calculate gross profit margin percentage
Initially, you need to determine gross profit, as above. From that, you can then determine gross margin as a percentage.
Gross profit margin formula
Gross Profit Margin (%) = [(Revenue – Cost of Goods Sold) ÷ Revenue] × 100
In case you’ve missed this, the gross profit margin formula uses your gross profit to calculate your gross margin. Written another way, the gross profit margin formula is:
Gross Profit Margin (%) = [Gross profit ÷ Revenue] × 100
For example, if your revenue is £500,000 and your cost of goods sold is £250,000, your gross margin calculation would be:
Gross Margin (%) = [(500,000 – 250,000) ÷ 500,000] × 100 = 50%
This means that for every £1 of revenue, 50p is left to cover operating expenses and generate profit.
TIP: Data gathered in your profit and loss statement is helpful in calculating gross profit and gross profit margin. LINK: What is a profit and loss statement?
Gross Profit vs. Gross Margin – What’s the Difference?
As you would have gathered, there is a significant difference between gross profit and gross margin, yet business owners use gross profit and gross margin interchangeably and -in doing so- miss out on the powerful insights that understanding gross margin will offer.
If you’re still struggling to fully understand the difference, don’t worry.
Let’s take another look:
- Gross Profit is an absolute figure, calculated as revenue minus direct costs. It tells you how much money you’ve made before overheads, but not in relation to revenue.
- Gross Margin is a percentage that shows how efficiently you generate profit from sales. It provides a clearer comparison between different products, services, or time periods.
For example, two companies might both have a gross profit of £100,000, but if Company A has a revenue of £200,000 (50% margin) and Company B has £500,000 (20% margin), the first company is operating far more efficiently.
If these two companies are compared by gross profits alone, they would appear to be equals in their field and likely to draw the same conclusions about their efficiency and success.
When compared by gross margin, however, we see that Company A is performing better as a business.
This same insight is helpful for both companies.
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The importance of gross margin in business
Now that you understand what gross margin is and how to use the gross margin formula to calculate gross margin, let’s look at the benefits of this critical business metric.
Measuring business efficiency with gross margin
The gross margin is a critical measure of business efficiency, reflecting how well a business manages its direct costs relative to the revenue generated. A higher gross profit margin shows that a company can efficiently convert sales into profit. This allows business owners to:
- Compare performance over time.
- Benchmark against competitors.
- Identify opportunities for reducing costs or increasing prices.
A declining gross margin can signal inefficiencies in your supply chain, pricing strategy, or production costs—giving you the opportunity to make improvements before profits take a hit.
Evaluating cost management
Your gross margin is directly affected by your ability to control costs. If your costs increase but your selling price remains the same, your margin shrinks.
By examining your profit margin, you can identify areas where the cost of goods sold (COGS) may be excessive. This could involve:
- Negotiating better supplier contracts.
- Reducing waste in materials or production.
- Improving operational efficiency.
By focusing on cost management and other cash outflows, companies can increase their profit margins and bolster their financial standing. Remember, every pound saved by reducing costs goes straight on your bottom line.
For more tips on how to improve your net cash flow, check out our article: 10 ways to improve your net cash flow.
Growth Potential Indicator and insights from gross margin
The gross margin also acts as an indicator of future growth potential.
If a business consistently achieves a healthy gross profit margin, it can reinvest in marketing, technology, or expansion. This reinvestment helps the company grow and maintain a competitive edge in the marketplace.
On the other hand, a declining gross profit margin may signal issues with pricing strategies, supply chain management, or operational inefficiencies, including a difficulty with operational cash flow; understanding this early on helps you adjust your strategy. Business owners must carefully monitor their gross margin to ensure long-term growth.
How gross margin offers insights for business growth
Scalability insights derived from gross margin are especially valuable for small businesses and startups. Suppose your gross margin remains stable or improves as your revenue builds.
In that case, it’s a good sign that your costs won’t drastically increase with growth, which can help attract investors or prepare for market expansion. By understanding this potential, you’re in a better position to decide if pursuing growth at your current gross margin is sustainable or, if adjustments are necessary to maintain profitability as you expand.
How understanding gross margin helps develop pricing strategies
Effective pricing strategies are designed to increase gross margin. The challenge for business owners is to strike the right balance between setting competitive prices and ensuring profitability. Check out our recent article on maximising profit using pricing strategies
A detailed understanding of your gross margin allows you to make more strategic pricing decisions. From a pricing perspective, the more detail you have, the better informed your decision making. By knowing the gross margin on all the products or services you sell, you will be better placed to price yours accurately within your market.
You may also be surprised by what you learn too, often we find that there are huge variations on the level of gross margin across the different products and services, which can highlight best strategies and direction in your business.
For example, after analysing your gross margin across different products and services, you may discover:
- Certain services or products are significantly more profitable than others.
- Some offerings barely break even and need repricing or removal.
- There’s an opportunity to increase prices without negatively affecting demand.
If you’ve never examined gross margin at this level before, you’ll likely find insights that reshape your pricing strategy entirely.
Attracting Investors and Financing
A strong business profit margin is often an attractive feature for potential investors or lenders. By demonstrating a healthy gross margin, businesses can signal their financial stability and growth potential, making them more likely to secure financing or attract investors.
For example, if you were an investor looking at our previous example of Company A and Company B, which would you feel more confident to invest in?
While both boast the gross profit of £100,000, Company A is clearly signalling higher efficiency and growth potential when we look at the gross margin.
How understanding gross margin leads to growth strategy in your business
Once you have gathered data on your gross margin for your business as a whole and also across more granular products or services, the next step is to analyse the data and use the information to increase your gross margin.
We have all heard of Pareto’s 80/20 rule; a theory maintaining that 80 percent of the output from a given situation or system is determined by 20 percent of the input.
What if 80% of your gross margin is being achieved by 20% of your product or service sales? How would this impact your business strategy moving forward?
And what about the other 80% of products / services that are only delivering 20% of the gross margin? It’s likely that you would need to make some tough decisions to adjust your pricing strategy, reduce headcount or expenses, become more efficient, or negotiate better contracts. Perhaps you would let go of costly product or service lines and prioritise those that will increase your profit margin.
Our Pareto example might sound extreme and yet -time and again- we provide these valuable insights to our customers who are then able to make data-driven and informed pivots within their business strategy, ensuring their business plan is update to see their gross margins increase.
We hope you now understand how to use the gross margin formula and why the insights it offers are so useful to your business.
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Frequently Asked Questions about Gross Profit Margin
What is the gross profit margin formula?
The gross profit margin formula is a simple way to understand how efficiently your business is operating.
Gross Profit Margin (%) = [(Revenue – Cost of Goods Sold) ÷ Revenue] × 100
The gross profit margin formula uses your gross profit to calculate your gross margin.
Written another way, the gross profit margin formula is:
Gross Profit Margin (%) = [Gross profit ÷ Revenue] × 100
For example, if your revenue is £500,000 and your cost of goods sold is £250,000, your gross margin calculation would be:
Gross Margin (%) = [(500,000 – 250,000) ÷ 500,000] × 100 = 50%
This means that for every £1 of revenue, 50p is left to cover operating expenses and generate profit.
What is gross margin?
Gross margin means the same as gross profit margin; the terms are often used interchangeably, however ‘gross profit margin’ is the more complete term.
Gross profit margin is a percentage that shows how efficiently you generate profit from sales. It provides a clearer comparison between different products, services, or time periods.
What’s the difference between gross margin and gross profit?
Two companies might both have a gross profit of £100,000, but if Company A has a revenue of £200,000 (50% margin) and Company B has £500,000 (20% margin), the first company is operating far more efficiently.
If these two companies are compared by gross profits alone, they would appear to be equals in their field and likely to draw the same conclusions about their efficiency and success.
What are the benefits of understanding gross profit margin in business?
The benefits from understanding your gross profit margin are numerous to both yourself as a business owner and strategist, and those to whom you are presenting your business, such as investors.
Gross profit margin indicates the health and profitability of your business.
