If you own a business, monitoring your profit margins regularly will give you the valuable data you need to identify the most lucrative areas of your business and scale them.
"Understanding your profit margins is particularly essential in navigating volatile times," says Claude Compton, Founder of Pave Projects, a London-based hospitality group. "Having a deep understanding of your profit margins allows you to be adaptable and pivot at speed while providing proactive leadership and fact-based decision making."
Here's a look at how to calculate gross profit margin.
What is the gross profit margin formula?
Gross profit margin is the percentage ratio of revenue you keep for each sale after all costs are deducted. To calculate it, you first need to calculate gross profit. Once you have your gross profit figure, you can use the following formula to calculate your gross profit margin.
Gross Profit Margin = Gross Profit / Revenue x 100
The gross profit margin is used to indicate how successful a company is at both generating revenue and keeping expenses low.
Gross profit margin formula example
As an example of gross margin, a shoe-maker might sell a pair of shoes for £50. They cost £15 to make, yielding the retailer a gross profit of £35. This equates to a margin of 70%.
- Total product revenue: £50
- Total production costs: £15
- Gross profit: 50-15 = £35
- Gross profit margin: 35/50 x 100 = 70%
Let’s take a service-based business. Imagine the company is an accounting firm that audits other businesses. A single audit sells for £500 and costs £100 to produce, yielding a gross profit of £400. This is a margin of 80%.
- Total product revenue: £500
- Total production costs: £100
- Gross profit: 500-100 = £400
- Gross profit margin: 400/500 x 100 = 80%
Why the gross profit margin calculation is important
The gross profit margin varies across products and sectors and is often used to measure the profitability of a single product. It indicates how efficiently you are using your resources to produce your goods or deliver your services.
“If a business has a number of projects or a number of products, then reporting on each separately is a great way to ensure that each component of the gross profit margin is performing as it should be,” says Compton. “Often, a lower result is due to one or two projects or products not being as profitable as expected.”
A strong understanding of your margins in business allows you to make quick decisions to support the growth and resilience of your company. For example, a spike might indicate a new trend that warrants additional investment, whereas a decline might highlight rising expenses, prompting you to analyse your cash flow and make cuts where necessary.
“We look at gross profit margins and specific key performance indicators in real-time daily and review in more detail on a weekly basis,” says Compton. “This regularity allows the business to ride out changing tides and isolate any issues before they become a long-term problem.”
As an example, by analysing your margins, a business will be able to pin down related price increases due to unexpected economic disruptions.
Knowing how to calculate your gross profit margins also helps you to better manage yourcash flow, ensuring there's always enough money to pay your suppliers and expenses on time. TheAmerican Express® Business Gold Cardhas a payment period of up to 54 days, giving you more control over your cash flow and when you make your payments¹.
What is a good gross profit margin?
A high gross profit margin generally indicates you’re making money on a product, whereas a low margin means your sale price is not much higher than the cost. But it’s important to remember that while these figures are a useful reference, margins vary widely by industry and company size.
For example, for auto and truck manufacturers, the average gross profit margin for the first quarter of 2023 was about 17% [1]. For consulting services, it was an average of 49% for the same period [2].
How to manage your gross profit margin
There are many different tactics you can use toimprove gross profit margin, but before adopting those you should make sure your business is doing the basics when it comes to managing gross profit.
Monitor your profit margins regularly
Compton undertakes a weekly review of his company’s profit margins. “We look at gross margins and specific KPIs in real-time daily and review in more detail weekly,” he says. "In 2020, it allowed us to steer the business through by isolating cost-cutting and revenue-driving areas, necessary to avoiding losses in a very challenging year for hospitality." For example, Pave could quickly spot recession-related price increases and implement technology to increase the speed of service and boost total sales revenue.
Use profit margins as a tool
Profit margins are a retailing tool. "You can flex your gross margin to sell old stock, increase footfall and increase loyalty," says Andrew Goodacre, CEO of the British Independent Retailers Association. For example, some retailers deliberately create "loss leading" products by keeping margins low, with the expectation of selling customers other more profitable items, he says.
Build them into your business model
A common reason for low-profit margins is the business model, says Goodacre. But this isn't always a negative. For example, budget supermarkets in the UK deliberately run low margins but with low overheads. Conversely, premium supermarkets operate higher margins in return for higher perceived quality.
Keep a long-term record
By regularly tracking your margins, you're growing a valuable pool of data that you can use to analyse performance over time and across markets. This can help you to understand the customer market that your business is attracting, says Goodacre. For example, by enabling you to spot whether a product is more profitable in one market over another or at certain times of the year.
1.The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – theBusiness Basic Card.
Sources:
[1]CSIMarket, Auto & Truck Manufacturers Industry Profitability
