Understand gross profit margin to boost your business

Gross profit margin is one of the key financial health indicators for your business – it measures the profitability of your operations and strongly affects the success of your business. Here’s what you need to know about it, how to calculate gross profit margin, and why it matters for your small business.

What is gross profit margin?

Gross profit margin is the percentage of your sales income left after you’ve paid for products you’ve sold or services you’ve provided. It also indicates how efficiently your business produces and sells its products or services.

An infographic showing the gross profit margin equation

Once you’ve then paid for operating expenses (like rent, office supplies, and interest on loan repayments) the remainder is your net profit.

Your gross profit margin shows what proportion of sales income you can keep in the business after covering your direct costs. Gross margins can also show areas where your business is profitable, and where it might be struggling.

Low gross profit margins make it harder to cover essential expenses like rent and energy, and reduce your chances of making a net profit.

Gross profit margin vs gross profit

Gross profit is an absolute dollar figure, while a gross profit margin (the proportion of your total revenue that exceeds your costs) is a percentage figure.

If you're wondering what gross margin is, it’s another way to refer to this same measure of profitability metrics, often used interchangeably with gross profit margin.

How to calculate gross profit margin

Gross profit margin (calculation)

The gross profit margin is your gross profit divided by revenue, times 100.

An infographic showing the gross profit margin equation

Gross profit margin formula explained

First, find your gross profit: take your sales figure and subtract your cost of goods sold (COGS). Then calculate the gross profit using the above gross profit margin formula for small business.

Gross profit margin example calculation

Let’s say your business makes $20,000 by cleaning offices. It costs you $8,000 to provide those services. Your gross profit is $12,000.

Your gross profit margin is therefore 60%.

An infographic showing a gross profit margin example
An infographic showing a gross profit margin example

Avoid common calculation mistakes

Make sure you estimate your COGS correctly, as it strongly affects the gross profit margin calculation.

Analysing gross profit margin for business insights

Gross profit margin analysis can help you understand the profitability and performance of each part of your business, so you know where you need to improve.

Competitively pricing your products can increase sales, while managing costs (which eat into your profit margins), will help to boost your margin.

Monitor your gross margin trends over time to reveal patterns in your business’s performance – such as where your revenue is strong (and where it isn’t), and how your costs change by product and time of year.

Factors affecting gross profit margin

Your gross profit margin can be affected by external factors out of your control:

  • Changes in demand – this affects the prices you can charge. If demand falls, for example, you might have to lower prices to entice customers
  • Rising supplier (input) costs – when costs rise (such as for materials and labour), your profit margins will narrow

Customers might also have less to spend as their own daily costs have gone up, potentially affecting your revenue.

What is a good gross profit margin?

A ‘good’ gross profit margin depends on your industry, the size of your business, and market conditions. Your gross profit margin needs to cover the costs of selling your products or services (your COGS) and the additional expenses like operating expenses and taxes.

Factors affecting your margins

Several key things influence how ‘good’ a gross profit margin might be.

Industry

Different industries have different cost levels and structures that affect margins. Hospitality, for instance, has high overhead costs and relatively low product costs, while financial services have lower overhead costs and higher service fees.

Region

Costs, expenses, and market forces vary wildly between regions. For instance, some countries have higher or lower taxes, and a big-city shop gets more footfall than a shop in a small village.

Business type

Ecommerce stores typically have lower overhead costs and more scope for sales than traditional retailers, and therefore potentially higher margins.

Market competition

The forces of competition in industries like electronics retail drive down prices, squeezing profit margins.

Benchmarking your gross profit margin

For a realistic picture of how your business is performing within your industry, benchmark your business against competitors in your industry.

You’ll get the clearest picture of your gross profit margin if you benchmark it against similar-sized businesses that operate in the same industry, market or region.

Industry benchmarks for gross profit margin

Gross profit margins can vary significantly in different sectors. For example, jewellery and cosmetics industries often achieve margins over 55%. On the contrary, industries such as electronics and alcoholic beverages may operate with margins below 45%. These differences reflect the unique environments of each industry.

Your accountant or bookkeeper can help find gross profit margin benchmarks for SMBs (other small to medium sized businesses) in your industry, and help clarify what your business should be aiming for.

When to reassess your gross profit margin

Evaluating and monitoring your gross profit margins is especially important in a changing market (when your costs might rise). It’s also good to look at them when conducting a financial performance analysis – for example, if you’ve missed your growth targets.

Your gross profit margin needs to cover the costs of selling your products or services (your COGSs) and other costs like operating expenses and taxes. Your accountant can help you pinpoint a gross margin for your business.

Accounting software like Xero’s financial reports make it easy to gauge your business’s performance.

Gross profit margin compared with other metrics

Here’s a quick comparison of the main differences between gross profit margin and two other business metrics, and how to use each one to work out the profitability of your business.

Gross profit margin vs operating profit margin

While gross profit margins only consider the cost of goods sold (COGS), operating profit margins are the next step in analyzing revenue vs profit, as they also account for other operational costs like rent and utilities.

Gross profit margin vs net profit margin

Net profit margin goes a step further than the operating profit margin. Net profit margin shows a business’s overall financial health, after taking into account your operating cost, as well as the deduction for interest and taxes. It’s the ‘bottom line’ profit.

How to use each metric

Use your:

  • Gross profit margins to analyse your COGs and to make pricing and resource allocation decisions
  • Operating profit margins together with your gross profit margins to determine your pricing, resource allocation and budgeting work
  • Net profit margins for long-term financial planning as businesses with consistently high net profit margins are more resilient to economic changes

How to improve gross profit margin

Small business owners can take basic steps to strengthen their gross profit margins.

Adjust your prices

You may need to update your prices as market conditions change. For instance, if a competing product is cut in price, you may need to change your own prices to prevent a dip in sales. Also think about improving your products or services to support higher pricing and improve margins.

Reduce your cost of goods sold

Your costs eat into your gross profit margin, so watch them closely. Find affordable suppliers and develop your relationships with them – you might get bulk discounts and better rates, improving your long-term costs.

Streamline your operations

Reduce waste and automate your processes – for example, by using accounting software – to cut costs and boost profit margins. For instance, effective inventory management can minimise excess stock, bringing down storage costs.

Use Xero to track your gross profit margin

Xero helps you stay top of your financial metrics as a small business owner. It makes it easier to follow your gross profit margin, and all business financial metrics, so you have more time to plan for your success.

Disclaimer

Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.