Understanding the Gross Profit Margin, Definition, Formula and Example

Gross profit margin is an important financial ratio used by firm management to assess profitability based on the amount of gross profit made on sales. Gross margin is the portion of sales revenue obtained after subtracting the cost of goods sold (COGS). 

However, the business should look at the gross profit margin as well as the net profit margin since it includes all costs, including operating costs, taxes, and interest. Understanding how to calculate the net profit margin is always useful as it provides full information about the company’s condition.

In this article, we will explain gross profit margin, its underlying meaning, and how it is computed using a simple formula. We will also provide an example to illustrate the concept.

Key Takeaways

• The profit margins portray your company’s profit level, financial position, and potential challenges in the near future.
• A good Gross profit is encouraged, but if the Net profit is low, the reason must be found.
• Controlling the amount of money spent is important if the maximum profits are to be generated.
• Profit margins always differ across industries, and thus, comparisons should be made across industries.
• If the calculations reveal problems, attention should be paid to more efficient cash resource management and the exclusion of unproductive expenditures.

What is Profit Margin?

Profit Margin determines a business or firm’s profitability. It is expressed as a percentage and represents how much of every dollar spent on sales or services your company keeps as profit. 

When net income is divided by net sales or revenue, a profit margin remains—the company’s costs are subtracted from its total revenue to create net income, which is also known as net profit.

How do you calculate net profit margin, and what is its formula?

The net profit margin is a key financial ratio that determines the percentage of the firm’s revenue remaining after operating costs, non-operating costs, taxes, and depreciation have been paid. 

It shows the company’s operational profitability and gives an idea of the company’s profitability other than just painting a picture of the business’s gross profit margin.

Net Profit Margin Formula:

Net Profit Margin = Net Income / Revenue x 100

Where:

• Net Profit = Total Revenue – All Expenses (COGS, operating expenses, taxes, interest, etc.)
• Total Revenue = Total income generated from sales or services

Step-By-Step Guide:

1. Firstly, calculate your cost of goods sold (COGS) and the income you’ll earn from selling these products.
2. Then, subtract the cost from the income to determine the gross profit.
3. Next, divide revenue by gross profit.
4. Finally, put it in percentage form.

Example:

Let’s assume a company has the following financial data:

• Total Revenue: $500,000
• Cost of Goods Sold (COGS): $200,000
• Operating Expenses: $150,000
• Interest and Taxes: $30,000

First, calculate the Net Profit:

Net Profit = Total Revenue – (COGS + Operating Expenses + Interest and Taxes)

Net Profit = 500,000 – (200,000 + 150,000 + 30,000) = 500,000 – 380,000 = 120,000

Now, use the formula to calculate the Net Profit Margin:

Net Profit Margin = (120,000 / 500,000) x 100 = 24%

Types of Profit Margins

There are three types of Profit Margin: 

• Net profit margin
• Gross Profit Margin
• Operating Profit Margin

The following table shows the definition, formulas, and example calculation: 

Profit Margin Type	Definition	Formula	Example Calculation
Gross Profit Margin	Measures the percentage of income left over after covering the cost of items.	Gross Profit Margin = (Gross Profit / Total Revenue) x 100	Example:Total Revenue: $400,000COGS: $250,000Gross Profit = 400,000 – 250,000 = 150,000Gross Profit Margin = 150,000 / 400,000 x 100 = 37.5 %
Operating Profit Margin	Represents the percentage of income remaining after operating expenditures but before taxes and interest.	Operating Profit Margin = (Operating Profit / Total Revenue) x 100	Example:Total Revenue: $400,000Operating Expenses: $100,000Gross Profit: $150,000Operating Profit = Gross Profit – Operating Expense = 150,000 – 100,000 = 50,000Operating Profit Margin = 50,000 / 400,000 x 100 = 12.5 %
Net Profit Margin	Represents the portion of revenue that remains after all costs, including interest and taxes.	Net Profit Margin = (Net Income / Revenue) x 100	Example:Total Revenue: $400,000Net Profit: $30,000Net Profit Margin = 30,000 / 400,000 x 100 = 7.5 %

Gross Profit Margin vs Operating Profit Margin vs Net Profit Margin

1. Gross Profit Margin

Definition

It gives the ratio of ((Total Revenue—COGS)/ Total Revenue). Gross profit margin measures the proportion of total revenue remaining after deducting the cost of goods sold.

Focus

Cost control efficiency: How well are the company’s direct costs, such as raw materials and employees, managed?

Includes simple and only CogOs, no operating expenses, taxes, or interest.

Example

It contributes to ascertaining the degree of goods production and sale and maintaining a company’s low production costs.

2. Operating Profit Margin

Definition

Suggestions the proportion of revenue that accrues from sales after suppressing both the cost of goods sold and operating expenses.

Focus

Internal efficiency indicates the effectiveness with which a business operates its day-to-day tasks (such as rent, utilities, and employees’ wages).

Includes the cost of goods and services sold plus operating expenses, which exclude taxes and interest.

Example

This also gives a glimpse of management’s strength in relation to its ability to manage various aspects of the organization other than manufacturing.

3. Net Profit Margin

Definition

 Amount of Sales – Cost of Sales – Advertising expenses – Taxes – Interest [Total Operating Expenses] x Revenue %

Focus

Gross profit demonstrates the company’s revenue after removing production costs. Specific profit generates a clear profit figure. Net profit displays the firm’s total revenue.

Includes: Cost of goods sold plus operating expenses plus taxes plus interest.

Example

Illustrates how much of it is actually produced after subtracting every expense accounted by the business.

What is a Good Profit Margin?

A good profit margin is simply a good sign of a company’s financial health and ability to translate its revenues into profits. 

Because what is considered ‘good’ may differ from one industry to another, a good profit margin is generally suggestive of the fact that the firm is in a good position to control its costs and achieve a good return on its sales.

Comparing Profit Margins

Profit margins are indicators of how much profit a business entity earns for each dollar of sales made. They’re generally divided into three categories: high level, moderate level, and low level.

1. High-Profit Margins

A high profit margin implies that a firm makes a very good profit compared to the sales it has transacted or the volumes of goods it has sold.

It could be because those companies enjoy a formidable pricing mechanism, a monopoly in the market, or a certain type of key superiority.

Examples: Programs that can be described as having low military use but extremely high civilian applicability include luxury cars or luxury brands and software companies with low production costs but high selling prices.

Margin Range: It is often 20% or more, while some industries may have different percentages depending on the type of training given and delivered.

2. Moderate Profit Margins

Moderate profit margins indicate that both factors have been well-balanced. Some of these organizations are making profits, though they could be more competitive or possess higher operational costs.

Examples: Long-standing businesses offering products or services for sale that are competitive in the market but not expensive associated with luxury brands.

Margin Range: Around 10-20%.

3. Low-Profit Margins

Low-profit margins mean that a company’s cost control could be better compared to its revenue. Such companies tend to be in industries characterized by high levels of competition or that provide low operating profit margins.

Examples: Shopping centers, supermarkets, mass merchants, and low price point businesses.

Margin Range: Fairly often, in the case of products, less than 10%.

Average Profit Margins by Industry

Your profit margin can help you assess how well your business is performing compared to competitors in your industry.

While there is no exact “good” profit margin, a healthy profit margin typically falls between 5% and 10%.

Following are some of the industries and their profit margins:

1. Banks: Banks have the highest average profit margin, both gross and net. Their gross profit was 100%, while the net profit was 30%—89% net.
2. Auto and truck: The auto and truck industry has the lowest average gross profit of 12—45%.
3. Software: Software entertainment is the least sensitive to profit margin, at 29%. 04%, system software, and application software have profit margins of 19%. 

Wireless broadband telephony contributes 32%, wireless local loop contributes 66%, and software (internet) has a profit margin of 2. 07%.

4. Real estate: The profit margin for non-residential building construction is 23, while the profit margin for miscellaneous real estate-related activities is 19. 

Real estate (development) has a profit margin of 6% while operating 75%. Sixty-five percent, while the operation and service of real estate have a margin of 3%. 59%.

5. Beverages: Spirit and wine-type alcoholic beverages have a profit margin of 7%. 94%. On the other hand, soft beverages have a profit margin of 18%. 50%.
6. Pharmaceuticals: This year, non-food products have a profit margin of 18%.The economic reward for this industry is pharmaceutical drugs, which account for 38%.

Ways to improve profit margins

Profit improvement can be achieved by enhancing sales revenue, reducing costs, or both.

Here are several strategies businesses can use to boost their profit margins:

1. Increase Prices (Strategically)

• Evaluate Pricing: One needs to factor in the service delivery value in one’s pricing strategy but should not overcharge customers.
• Offer Premium Products/Services: Expand your product range and offer more expensive, premium versions of the products you sell to earn more money per individual sale.

2. Reduce Direct Costs

• Negotiate with Suppliers: Negotiate with the suppliers to offer cheaper material in the company or buy in large quantities to save on costs.
• Use Cheaper Alternatives: Focus on a lower-cost option that will deliver a similar quality to the client.

3. Optimize Operational Efficiency

• Streamline Processes: Reduce or eliminate time-consuming steps, which can be done with either lean management or automation.
• Reduce Waste: Optimise the efficient use of time and other resources by enhancing operations efficiency and productivity.

4. Improve Sales Mix

• Focus on High-Margin Products: Encourage and give preference to products or services with higher profit margins.
• Upsell and Cross-sell: Cross-sell related products, offer complements to a product, or offer a better model of a product to the customers.

5. Control Overhead Costs

• Cut Unnecessary Expenses: When it comes to the business expenditure review, coordinate contentious issues such as utilities, rent, insurance, etc., and only spare what is needed.
• Outsource Non-core Tasks: Hire third-party services such as an accountant, a marketer, or an IT specialist whenever it is cheaper to source such services externally.

6. Improve Inventory Management

• Reduce Inventory Holding Costs: Implement the just-in-time inventory strategy since this will only mean buying or stocking what is needed rather than stocking everything in large quantities.
• Implement Just-In-Time (JIT) Inventory: Redirect resources, cut excess stock, and improve cash flow through the implementation of JIT inventory methods.

7. Enhance Customer Retention

• Focus on Loyal Customers: It is usually less costly when companies are able to retain a number of their consumers than when they focus on sourcing for new ones—loyalty programs, selling services or products with motivated customers, or offering personalization to customers.
• Increase Lifetime Customer Value (LCV): Ensure efficient after-sales service and related back-end products are offered with preventive intent to ensure customers keep using the firm’s products and services in the future.

8. Optimize Marketing Spend

• Focus on High-ROI Channels: Distinguish between and assign more resources to the marketing channels that produce the highest ROI, and conversely, reduce the resources channeled to the low-yield channels.
• Use Data for Targeting: Use a customer database to develop marketing promotions that are far-reaching and inexpensive.

9. Leverage Technology

• Automation: Applying software or tools to accomplish routine work such as accounting, payroll, and customer service to minimize time spent and cut labor expenses.
• Adopt E-commerce or Digital Solutions: Sell any inventory online in an attempt to eliminate many of the in-store costs that are incurred.

10. Improve Employee Productivity

• Train Employees: Spend money on the training and development of your employees so that your organization’s workers can work efficiently.
• Offer Incentives: Introduce a reward system that requires gift-back from employees, which can favor the company’s profitability.

The Bottom Line

Analysts and investors may use various criteria to assess whether a firm is financially healthy. One of them is the profit margin, which calculates the company’s profit as a proportion of total sales. In layperson’s terms, a company’s profit margin is the total number of cents per dollar received from a sale that may be retained as profit.

The most common and extensively used profit margin is the net profit margin, which includes all of a company’s direct and indirect costs.

Frequently Asked Questions

How to Figure Out the Profit Percentage?

To figure out your profit %, first remove your entire expenditures from your total revenue. Then, divide the profit by the entire revenue. Finally, multiply the value by 100 to calculate the percentage. The formula for calculating profit percentage is (profit ÷ revenue) times 100. This tells you what proportion of your revenue is profit.

How can I determine a 20% profit margin?

Take these steps:

• Convert 20% to decimal form (0.2).
• Subtract 0.2 from 1, and you get 0.8.
• Multiply your item’s original cost by 0.8.
• The outcome is the price you should charge to make a 20% profit margin.

How do you manually compute profit margins?

To manually determine a company’s profit margin, remove the cost of goods sold (COGS) from the total sales and divide it by the total revenue. To calculate the percentage, multiply the outcome by 100. For instance, if a firm has $1,000 in revenue and $200 in COGS, its profit margin is 80%, computed as ($1,000 – $200) ÷ $1,000 × 100.

Which profit margin formula is more useful?

The net profit margin formula is frequently the most useful since it takes into account net income. Investors, creditors, and business executives all pay attention to the company’s net income or bottom line.

What constitutes a strong net profit margin?

A healthy profit margin varies by sector and firm size, but a 20% margin is considered outstanding, while a 5% margin is considered poor.

How do you measure profit from sales?

To determine profit on sales, use this formula: Total Revenue – Total Expenses = Profit.