Accounting Math: What Exactly is the Gross Profit Margin?
Your superpower as a business owner is to run your business as though you intend to sell it. A company whose books check out to a third-party reviewer is strong, healthy, efficient, and primed for future growth. All attributes are precisely what a buyer would require. That said, a few key financial metrics are imperative to potential buyers. Putting a lens over them can help business owners make their businesses more profitable- note: higher profit, not higher revenue, per se– and ultimately more valuable. Everyone wins when you increase the value of your business.
Of the many magic metrics to cover, we’ll look at gross profit and gross profit margin. While the two terms mean different things, they are closely connected.
So what exactly is the difference?
Calculating your gross profit is as simple as calculating the entire revenue made from the products and services you provide and subtracting the fees related to producing, promoting, and providing those products and services.
Revenue is the total money made on a product or service line. Because returns and discounts are a part of doing business, your Net Sales is calculated by subtracting all returns and discounts from your total revenue.
Cost of Goods and Services (COGS)
The Cost of Goods and Services is the term that is generally attributed to the collective costs that are specific to building, promoting, and providing each product or service.
This figure includes all costs of materials, all shipping fees related to those products, and any other fees, like credit card fees. While wages are generally not calculated as a part of the COGS, any wages and commissions directly related to the sales of those products and services should be included in the COGS. Fixed fees such as salaries for non-sales professionals, rent, utilities, and advertising costs are not reflected in this amount.
Example: Nathan, an arts and craft dealer, works with area artisans who create high-end paintings. Nathan provides the materials to the artisans and sells each painting for $20,000. Last year (the numbers always need to be from the same period) he sold 100 paintings for a total revenue of $2,000,000. The paintings are of such a high-quality Nathan didn’t have any returns, nor did he offer any discounts on these products. So in this example, his total revenue and his net sales are one and the same.
The cost to produce and sell those paintings includes $100,000 for the paints and canvases, $1,000,000 in fees to the local artisans, a $50,000 commission to his son, who helped sell and ship the paintings, and $50,000 in shipping and insurance to carefully deliver these high-value products.
Revenue: $2,000,000 (100 paintings at $20,000 each)
Returns & Discounts: $0
Net Sales: $2,000,000
COGS: $1,200,000 (materials, salaries, commission, shipping, and insurance)
Gross Profit: $800,000
That’s a decent profit for a year’s worth of work. Right?
Gross Profit Margin
Here’s where the gross profit margin comes in, as it gives a more contextual look at your financial numbers while also giving buyers and brokers a way to see the bigger picture when compared to similar businesses.
To calculate the Gross Profit Margin, don’t worry, it’s one of the few simple formulas. First, calculate the Gross Profit as defined above. And then divide the Gross Profit by the Net Sales.
The Math: As defined above, Nathan’s gross profit for the deluxe paintings was $800,000 and his net sales were $2,000,000.
His total gross profit margin for the deluxe paintings was 40%.
KM - This means that 40% of total revenue is available to cover general expenses for the company. For every dollar that Nathan makes, he spends
Good or bad - efficient to industry
Calculate the Gross Profit Margin for Each Product Line
After a few years in business, Nathan realized he had plenty of materials and paints left over after divvying out most of them to the artists he works with.
So he started a second product line. In this, he would send the remnant materials to student artists in the area, and in return, he would sell their artworks at a lower “future artists” price point..
Because this is a separate product line for Nathan, he would calculate the gross profit margin of the student paintings separately from the gross profit margin of the deluxe paintings.
Example: Last year, student artists crafted 1,000 paintings. He sold half of those paintings at $1,000 a piece for a total of $500,000. He also sold half of the paintings at a 50% discount to local art galleries for a total of $250,000. Combined, his total revenue on the student paintings was $1,000,000 minus the $250,000 in discounts, for a total Net Sales of $750,000.
Nathan estimates that he uses about 20% of the materials he receives for the larger paintings, for an estimated cost of $20,000. His shipping and insurance costs are nominal because he only sells the products locally, but the percentage in commissions paid to his son jumped dramatically, as the son does all the store-to-store outreach. Commissions on the student paintings cost Nathan approximately $100,000.
Revenue: $1,000,000 (1,000 paintings at $1,000 each)
Returns & Discounts: $250,000 discounts for local art galleries
Net Sales: $750,000
COGS: $120,000 (materials, commission)
Gross Profit: $630,000
Gross Profit Margin: 82%
What is a Good Gross Profit Margin?
You can see from the example above that Nathan’s Gross Profit Margin on the student painting is a healthy 82% while the gross profit margin for the deluxe patients is a slightly lower, but still robust 40%.
What does that mean?
While Nathan made larger net sales on the deluxe drums, he kept more money–made a larger profit–selling the student paintings.
Not only did Nathan find an efficient way to use leftover materials, but he also built a second profit stream with a healthy gross profit margin that will help make his numbers look even more appealing to potential buyers.
How Can I Improve My Gross Profit Margin?
For Nathan to increase the Gross Profit Margin on his deluxe painting line, he has two options, raise prices or lower the cost of goods. Because he already sells the paintings at a healthy $20,000, raising the prices could affect the number of sales, so this might not be the correct choice for Nathan.
Alternatively, Nathan could find a way to lower his costs. In this overly simplified example, he has three options: Find new materials suppliers, pay the artists less for their work, or pay his son less for his outreach and sales efforts. None of the choices are optimal, but finding a supplier who offers the same quality materials at a lower rate would be Nathan’s best bet to increase his profit margin.
How to Allocate Expenses for my Service Business?
The Gross Profit Margin is not a metric reserved strictly for businesses that produce tangible products. It also applies to service businesses. In this case, instead of calculating the cost of materials, service businesses must carefully calculate how they allocate their expenses specific to each service.
Example: Nathan’s business model is so successful, that area retailers and wholesalers throughout the state are looking to replicate it. During the past year, Nathan developed a third revenue stream–a consulting business where he advises store owners on how to work directly with artists.
For this service-based component of his business, Nathan didn’t have hard costs like materials. So how did he calculate the Gross Profit Margin on his service line?
Example: Nathan worked with five area shops, charging each a monthly consulting fee of $5,000, for a total “net sales” of $25,000 per month o4 $300,000 for the year.
His hard costs were minimal, mostly subscriptions to marketing and email tools that specifically promote the consulting service, for a total cost of $1,000 for the year. He also purchased five pieces of art from his student line ($5,000) as thank you/incentive gifts for the shop owners he works with.
Nathan estimates that he spends about 20% of his time working on his service line. Since he earns a total salary of $200,000 for the year, he estimates approximately $40,000 of that is directly focused on the service business.
Net Sales: $300,000
COGS: $46,000 (marketing, gifts, targeted salary)
Gross Profit: $254,000
Gross Profit Margin: 85%
Although Nathan’s service line brings in the lowest total Net Sales, the low cost of goods and services on that service line catapults it to a healthy 85%.
What Nathan realized is that while it was impractical to raise the sales price of the deluxe painting and it was difficult to lower the fees required to produce those paintings, building additional revenue streams with higher Gross Profit Margins helped improve his overall financial outlook.
What does all this mean?
Find an Expert
As with all business metrics, calculating gross profit margin is a complex equation with many variables that are ultimately best served with the help of certified accounting and valuation professionals.
Kate McMahon is Raincatcher’s resident Certified Valuation Analyst. If you haven’t already, you should check out her podcast: Getting the Most Out of Your Business.
If you’re ready to start talking about selling your business, the professional business brokers and valuation analysts at Raincatcher have advised hundreds of business owners to increase the profitability of their businesses.
If you’re already preparing your business for sale, the staff at Raincatcher can work with you to build the best story for your Gross Profit Margin in order to close a sale at an attractive price.