The original formula for gross profit is the total business revenue (usually equating to total sales value). From that, we subtract the original cost of goods or services and the expense of getting them to consumers. While gross profit is important to a company’s income statements, gross profit margin is something entirely different. First – gross profit is given as a currency value.
Gross profit is not an accurate indicator because gross profits may rise while gross profit margins can fall. They can also vary considerably between industries. Beverage makers may have considerable gross profit but very slim profit margins and rely on volume. An antiques dealer with a huge markup may have moderate gross profit but a substantial profit margin. In this article, let’s take a look at the significance of gross margins for businesses of all sizes.
What Is Gross Profit Margin?
Some companies and people will use the term vaguely, such as “gross profit” or “gross margin”. It’s important to remember that gross profit is total sales minus the cost of those goods; profit margin is always expressed as the ratio or percentage between revenue and cost.
It’s critical for any business, especially small companies who may have limited product lines or specialized services, to understand how well they are doing versus the actual costs involved. Higher revenue does not always mean better profit. Companies that track and manage their profit margins are better able to control costs.
Who Uses Gross Profit Margin?
Understanding gross margin is important for a number of business functions. CEOs, CIOs, marketers, salespeople, and accountants all need to know profit margins. That’s in order to gauge cost-effectiveness and make efficient business decisions. It helps companies manage pricing when considering costs that are too high, or products that need to generate more revenue. When sales are up but profit margins are still low, crucial decisions on pricing, supply chains, and internal operations may be impervious.
For instance, a baker may experience a hike in sales volume after introducing a new cookie. But after examining gross margins, they’re actually losing money. Business executives, sales managers, purchasing agents, and production managers must meet to determine if a price hike is in order, whether margins can be improved with cheaper ingredients or more efficient processes, or whether cookie production should be abandoned altogether.
How do You Obtain the Gross Profit Margin?
Gross profit typically considers only variable costs in production, as opposed to fixed costs such as insurance or rent, which can be amortized per unit produced. Variable costs are those that typically fluctuate according to the level of output, such as materials, labor, commissions and bonuses, or equipment overhead and depreciation. Gross profit is a different concept than operating profit, which is earnings minus tax and interest.
The gross profit margin formula is: gross profit / revenue.
Let’s say an entrepreneur car maker sells 50 units of a new model at $18,000 each for a total revenue of $900,000. But each car costs $16,500 to make, for a total cost of $825,000. The difference is a gross profit of $75,000. Dividing by $900,000 revenue gives us a gross margin of 8.3 percent, which is actually quite low for the automotive industry.
For established businesses, margins typically rise and fall. Tracking profit margins are useful for providing companies a high-level perspective of production efficiency over time.
Six Ways in Which a Good Gross Profit Margin Can Help Your Business
- The Bottom Line: Establishing a good gross profit margin is the first step in building optimal profits for your company. Good margins indicate surplus cash for improving operations. For small businesses, the faster you pass the break-even point and see growing profit margins, the faster you grow.
- Cash Flow: Gross margin gives an indication of your cash flow. Companies usually invest a good part of their returns into raw materials or products. Improving your gross margin gives you the confidence that you’ll be able to turn around and sell these goods for a given return. You’re able to plan better knowing the expected revenue from your inventory.
- Pricing: Understanding your targeted profit margins makes it easier to adopt the right pricing strategy. For instance, if you’re selling a food processor for $110, and a big chain retailer starts selling the exact same model for $99, you have to find a way to cut costs to stay competitive and keep margins.
- Product Line: Monitoring gross margins can help you select the right combination of products to stay profitable. Most companies will sell cheaper products in volume for lower margins along with more pricey merchandise that sells less often but provides greater margins. Customers will have different tastes or needs in product selection. However, profit margins set the guideline for adjusting product lines to stay profitable.
- Cost: Margins also suggest to managers when it’s time to step in and take control of both direct and indirect costs. Companies pay expenses such as marketing or administration salaries regardless of actual sales, but a drop in profit margins can force companies to analyze these and other expenses to minimize expenditure and improve gross margins.
- Benchmarking: Margin targets are useful for setting benchmarks to assess and improve performance. Often these come from industry or historical standards that follow best practices and competitive rates to set appropriate margins. They may also be familliar within companies to compare various locations, departments, and products to evaluate market performance.
In sum, you need to understand what gross profit margin is and how it can help your business evaluate success. This should be a core component of your business strategy. It provides a simple, constant metric that can identify issues, suggest changes, or validate improvements.
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