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Business Unplugged™
This blog features Carol Roth's tough love on business and entrepreneurship, as well as insights from Carol's community of contributors.

Understanding Your Bottom Line: Gross Profit Margin

Written By: Nicole Fende | No Comments

The first time that I heard this term, I wondered why anyone would call profit gross.  Lackluster, paltry, acceptable or even excessive I could understand.  But gross?  That’s a word you use for baby puke and the genius who took a bath in a fast food kitchen sink.

Despite the unsavory name, Gross Profit Margin is a key number in running your business.  Your Gross Profit Margin tells you at a glance about your efficiency and gives you a way to quickly compare to your competitors.  This term also has a few aliases, most notably Gross Margin and Gross Profit Margin Ratio.

Learn How Gross Profit Drives Your Bottom Line 

The first step is calculating your Gross Profit.  Don’t worry; this is a really simple formula.

Gross Profit = Total Revenue – Cost of Goods Sold (COGS)

I’ve defined the numbers below.  They need to be from the same period.  Try starting with your results from the last calendar year.

  • Total Revenue – Total monies received from customers during the period.
  • Cost of Goods Sold (COGS) – This one is tricky, and not just because I keep seeing clogs every time I read it (someday, I’m going to find the person who created these terms and beat them with a wet noodle).  Cost of Goods Sold includes only the expenses directly attributable to creating the product or service.  Examples would include raw materials and direct labor costs.  It does not include distribution expenses or general overhead.
  • Further information on the IRS position regarding Cost of Goods Sold can be found here.

Your Gross Profit must be sufficient to cover all of your remaining expenses and have enough left over to meet your net income goals.  In other words, your Gross Profit needs to pay all remaining business expenses AND pay you.  If your Gross Profit is not big enough, you won’t earn your target income and the business may even lose money.

Makes sense, so why do you need to calculate the Gross Profit Margin?  What else will we learn?

Calculating Gross Profit Margin

As with Gross Profit, be sure all of the numbers are from the same period.

Gross Profit Margin = Gross Profit / Total Revenue

Now, let’s take a look at an example and see Gross Profit Margin in action.

Example Calculation of Gross Profit Margin

Total Tortillas is a small business that produces tortillas for local restaurants and grocery stores.  In 2011, Total Tortillas brought in $250,000 in revenue.  Their cost for ingredients to create the tortillas was $120,000.  The labor to make the tortillas was $60,000.  The cost to distribute the tortillas to clients was $10,000.

  • Total Revenue = $250,000
  • Cost of Goods Sold = $180,000 (120,000 + 60,000) – cost to distribute is not included
  • Gross Profit = $70,000 ($250,000 – $180,000)
  • Gross Profit Margin = 28%

($70,000) / (250,000)

Only 28% of total revenue ($70,000) is available to cover general expenses, distribution and profit for this company.  In other words, for every dollar that Total Tortillas is paid by a customer, they spend 72 cents on creating their product.

I’m sure you’re wondering, is that good?

Decoding the Meaning of Gross Profit Margin

Believe it or not, statistics are tracked by the U.S. government for “Bakeries and tortilla manufacturing.” You can access summaries of this data for free on www.BizStats.com.  In 2008, the average Gross Profit Margin Ratio for a tortilla manufacturer was 34.15%.  That means that Total Tortillas was less efficient at 28% than their average competitor.  In this particular case, that is not good news.

However, analyzing your ratio depends on the type of business you run.  A manufacturing business is going to have a much lower Gross Profit Margin Ratio than a professional services business. 

Why?

A professional services business does not require substantial materials or raw goods to deliver a service to their client.  That means that most of their expenses are not included in COGS.  Going back to Biz Stats, we can look at data for Accounting, tax preparation, bookkeeping, and payroll services. The Gross Profit Margin Ratio for this category is nearly 86%!

Clearly, it’s imperative that you compare apples to apples when benchmarking your Gross Profit Margin!

Final Thoughts

Not only can Gross Profit Margin provide you with an objective benchmark versus your competition, it also gives a quick and easy way to look at your efficiency for any given period.  If efficiency is crucial to your bottom line, I recommend running this number every month.

Care to share your results?  Or how do your results stack up compared to the industry standard?

Article written by
Nicole Fende is The Numbers Whisperer™. Her mission is to free small business owners from the fear of finance and humor is her weapon of choice. In her new book, How to be a Finance Rock Star, Nicole draws on her worldwide experience in companies large and small to help businesspeople overcome their fear while making finance fun. Want to give your finance fears the boot? Sign up for Nicole’s free eCourse.