What is the gross profit margin formula and how is it calculated?

Revolut Contributor

 · June 24, 2020  · 06/24/2020

The gross profit margin formula is a simple one, yet it has some nuances which deserve a coherent explanation. First, let’s recap on what the term means. Gross profit margin is a ratio that reveals how much profit a business makes for every pound it generates in sales before accounting for its indirect costs. These are the variable costs that relate directly to achieving sales, such as the raw materials of goods that the business makes or sells.

What is the gross profit margin formula?

Take the figure shown for gross profit on the income statement of the business and divide this monetary value by the total revenue over the same time. The result is a ratio, which is multiplied by one hundred to express the gross profit margin as a percentage.

Gross Profit Margin (%) = (Gross Profit / Revenue) x 100

What’s tricky is that people tend to describe the terms in this formula with different words. For instance, revenue is called total sales or turnover, and indirect costs are commonly known as the cost of sales or the cost of goods sold (COGS). This final point is especially true for a business that makes or resells products.

We cover gross profit in more detail here. The same link also shows how to calculate gross margin, which is ultimately just another way of saying gross profit margin.

How do you calculate the gross profit margin?

The first step is to grasp the principle of direct costs. These are the costs that vary depending on the level of production of a good or service. The majority of indirect expenses – often called fixed costs or overheads – are apparent, such as the rent paid on a factory.

Sometimes, this distinction is less clear. For instance, the wages of the sales team are technically a direct cost, as opposed to those of the administration team, which are indirect. In the real world, it’s often impractical to separate salaries into these two different categories.

This principle means that it is common to consider the total value of payroll as a single cost within the operating expenses. Under this approach, the cost of wages is subtracted as part of the calculation to reveal the operating profits and then the net profits of the business.

Aside from the book-keeping simplicity, a side-benefit is that this will artificially maintain a chunkier gross profit margin percentage. There is nothing wrong with this as managers have wiggle-room over how to categorise these costs, and usually provide notes in the accounts to explain any such decisions. But do not imagine that it will go unnoticed by the analysts or investors who pay close attention to the gross margin of the business.

What is a good gross profit margin?

There is no straightforward answer as gross profit margins vary hugely between industries or even sectors within them. It’s better to compare each figure to the industry benchmark in the same sector and observe how this changes over time than to worry about abstract targets. {link RB17}. It’s vital to take seasonal factors into account too. For example, the gross profit margin over the winter period might differ greatly to that of the summer in specific industries.

What matters is to understand the real-world implications of the gross profit margin formula. For example, the software that many retailers rely upon to track their financial ratios is often sophisticated. Still, this tends to include only the invoice cost of a product in its gross margin calculations. Once we appreciate the true nature of the gross profit margin formula, we realise that several other direct production costs, such as shipping, must also be deducted.

These costs are why there is often a discrepancy between the projected gross profit margin in a tracking system, and the figure that emerges once the financial statement of a business is ready. Retailers, in particular, must maintain a laser focus on this profit ratio to be viable.

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