What is a Gross Profit Margin?
Your profit margin is impacted by so many factors, such as price, volume, and even sales region. So knowing your way round your profit margins can give you valuable insights into understanding what exactly is driving your margins, which will help in making those bigger and trickier business decisions.
If you know how to calculate and analyze a profit margin, you’ll gain insight into your company’s current effectiveness in generating profits, as well as its potential to generate future profits. But before we explore the world of profit margins and margin analysis, we need to first understand the profit margins themselves.
There are three key metrics to look out for when analyzing profit margins:
Gross profit margin – Gross profit margin (GPM) is a financial metric that shows you how efficient your business is at managing its operations. It’s basically a metric that compares the performance of a company’s sales to the efficiency of its production process.
Operating profit margin – Comparing earnings before interest and taxes to sales, you can calculate this metric to show how successful a company’s management has been at generating income from the operation of the business. If you’re finding this is increasing over time, then this is indicating to a consistent and healthy bottom line in your company.
Net profit margin – This is the main financial metric that investors and analysts look at when it comes to the profitability of businesses. This is generated from all phases of a business, including taxes. In simpler terms, this metric compares net income with sales.
In this article, we’ll be focusing on gross profit margin and its margin analysis as it’s a key measure in understanding both a company’s efficiency and profitability. It’s an extremely important measurement, especially to your investors, that tells you how your business is doing, and whether changes need to be made.
How to Calculate Gross Profit Margin
In their margin analysis, most businesses measure their gross profit margin using a percentage, and so the formula to calculate your GPM is:
Gross profit margin = (Net sales – cost of goods sold) / Net sales x 100
For example, imagine a company has $3 million in sales and the cost of its production adds up to $750,000. The GPM rate for this company would be 75%.
But how do you know if your GPM rate is any good? Well, a higher rate will tell you that your company has more money left over to pay for its operational expenses, therefore investing more into the business. You can use the money to increase cash flow, expand other projects, increase spending on marketing, or even build new production facilities.
Whereas a lower rate would be indicating that your company has a lower percentage of sales that can be used to pay for operational expenses, and so a much more limited budget. You have very little money to do anything other than keep making products at the same level, meaning your business is simply not growing.
What’s important to note is that not every industry will have the same ‘good’ GPM rate, and there can be significant differences between industries. Here are some examples of the average GPMs for the typical industries we work with:
- SaaS: 67%
- Beverage (Alcoholic): 49%
- Consumer Goods: 51%
- Information Services: 51%
- Beverage (Soft): 56%
Margin Analysis: Interpreting Gross Profit Margin
Once you know what your company’s GPM is, you now need to be able sit down and interpret your margin analysis, figuring out what exactly this means for your business. If your GPM is below average, when compared to your industry average, is it because of lower sales? Or possibly something bigger? Here are some of the key factors that may be causing your GPM to be on the lower side:
Production efficiency – A low GPM, especially one that is continuously dropping over time, could be telling you that your company isn’t producing your products efficiently. One aspect to look at in the production process is the materials. If you can reduce the costs in this area, your overall production costs would decrease and so your GPM would go up.
Another aspect to look at, which is more related to the efficiency element, is the cost of labor. Is your equipment up to scratch? Do your workers need more training? If you can decrease the cost of labor, you’ll see your company’s GPM start to increase.
Sales – Low sales doesn’t always mean that your GPM will be low, but if your sales don’t quite cover the other expenses in your business, then this would cause your GPM to drop.
Pricing structure – A poor pricing strategy can cause GPM to drop to a low level. If you can increase prices while maintaining sales, the total sales figure will increase but the costs stay the same. And this would mean your GPM would increase. You could also try to increase sales and keep the pricing at the same level, which could lead to some savings in the production costs due to the higher volume.
Margin Analysis is the Way Forward
We know what you’re thinking – GPMs and margin analysis sound a little confusing, especially if you’re a business who’s just starting out. But that’s where Simple Startup can help. We can support you in improving your margin through our fractional financial services. We can assist your company through the analysis of your multi-channel revenue sources, analyze the impact and magnitude of the variables, and develop tangible action plans to maximize profits. So why not grab some time with us on our calendar and see how we can support you today!