What it means
Gross profit is revenue minus the cost of goods sold, which covers materials, direct labour and other costs that rise and fall with production. The margin turns that figure into a percentage of revenue so that businesses of different sizes can be compared.
A bakery and a software company can be measured on the same scale, even though their cost structures look nothing alike. The ratio is a first test of pricing and production efficiency.
If it falls, either prices have dropped, input costs have risen or the business is making less efficient use of its labour and materials. Managers use it to spot problems early, because it moves before overheads and interest muddy the picture.
Typical margins vary hugely by industry. Software and many services businesses commonly report very high margins, while supermarkets and wholesalers operate on thin ones and make money on volume.
A figure that is excellent in one sector can be alarming in another, so comparisons only make sense within the same industry. What counts as a direct cost is a matter of policy, and this can change the margin without any change in the business.
One company may put warehouse wages into cost of goods sold while another treats them as overheads. When comparing firms, look at how each defines its costs before drawing conclusions.
Gross margin is also the starting point for pricing decisions and sales targets. A company that knows it needs a 40% gross margin to cover overheads and still make a profit can work backwards to the lowest price it can accept on a given product.
Sales teams offering discounts should know exactly how much margin each discount removes. The nuance is that gross margin and markup are different measures.
Margin is profit as a share of selling price, while markup is profit as a share of cost, and mixing them up leads to prices that are too low.
In practice
Real-world examples
Example 1
A coffee roaster sees its margin drop from 45% to 38% in a year. The finance manager traces the fall to a rise in green coffee prices that was not passed on to wholesale customers.
Example 2
A software company with a gross margin of 82% considers hiring more support staff, treated as a cost of delivery. The finance director calculates that adding $600,000 of support cost to a business with $10,000,000 of revenue would lower the margin by six percentage points.
Example 3
A sales manager at a building supply distributor is asked to approve a 10% discount on an order. Finance shows that, because the product earns a 22% gross margin, the discount would remove almost half of the profit on the deal.
Think of it
Gross margin is like the markup on products before paying rent, salaries, and other overhead expenses.
Formula
Calculation
Gross profit margin = (revenue - cost of goods sold) / revenue x 100
Suppose a furniture maker sells $800,000 of products in a year and the direct costs of materials and workshop labour are $520,000. Gross profit is 800,000 - 520,000 = $280,000. Gross profit margin = 280,000 / 800,000 = 0.35, or 35%. If a price cut of 5% lowered revenue to $760,000 with the same costs, gross profit would be 760,000 - 520,000 = $240,000 and the margin would fall to 240,000 / 760,000 = 31.6%.Case study
Seen in the real world
Oakhurst Apparel is an illustrative, fictional clothing brand whose sales had grown 30% over two years, yet profits stayed flat. The board assumed overheads were the problem and began planning cuts to the head office.
The finance director produced a gross margin analysis by product line. Sales growth had come mainly from a discounted range that earned a 28% margin, compared with 52% on the core range, so the more the company sold the lower the average margin fell.
The business reduced its promotions, raised the price of the discount range slightly and refocused advertising on the core products. The illustrative lesson is that a falling gross margin can hide behind rising sales, and looking at it by product shows where the real profit is.
Watch out
Common mistakes
- Confusing gross profit margin with net profit margin, when gross margin ignores overheads, interest and tax.
- Comparing margins across industries with very different cost structures and concluding one business is poorly run.
- Mixing up margin and markup, so that a 30% markup is wrongly treated as a 30% margin and prices end up too low.
Questions
People also ask
What is a good gross profit margin?
It depends on the industry, with software often well above 70% and grocery retail often in the low double digits or below, so compare against similar businesses.
Why did my gross margin fall when sales went up?
Common causes are discounting, a shift towards lower-margin products or rising input costs that were not passed on in prices.
Should labour be included in cost of goods sold?
Direct labour that varies with production usually is, while administrative and management salaries are normally treated as overheads.
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