Evaluating gross profit margin is difficult because every business is unique. For example, companies prioritizing sales volume amongst their strategies or operating in highly competitive markets trend towards lower gross profit margins despite maintaining healthy finances.
Industry-specific baselines and the context of your broader strategies are critical to gaining insight from your gross profit margin. Without these pieces to the bigger puzzle, individual businesses will have a difficult time answering: “What is a good gross profit margin?”
The best method for determining a good gross profit margin involves comparing your percentages to sector averages (and alongside operating margin and net profit calculations) to identify ratios good for your business.
What is Gross Profit Margin?
Gross profit margin (sometimes referred to as “gross margin” or “gross margin ratio”) is one of the primary metrics used to evaluate a business’ health and competitiveness within its industry. Measured as a percentage, gross profit margin will tell you how much revenue your products and services generate per dollar after subtracting your cost of goods sold.
Determining this ratio is most helpful for assessing individual goods and services.
While gross profit margin remains an important metric for businesses to track, it gives an incomplete impression in isolation. Your company also must account for other operating expenses—such as other employee wages, facilities overhead, and taxes—that do not factor into calculating your gross profit margin. Trying to gain insight from gross profit margin alone is like declaring a jigsaw puzzle finished when you only have one-third of the pieces.
Calculating Gross Profit Margin
You still need the pieces provided by gross profit margin, though, to complete the picture. Thankfully, calculations are simple:
- First, determine your net sales amount.
- Calculate your net sales by subtracting all returns, refunds, and discounts from your gross sales (i.e., overall sales before factoring in any costs).
- Subtract your cost of goods sold (COGS) from your net sales to determine your total gross profit.
- COGS includes all costs required to produce your goods and services.
- Divide your gross profit by net sales to quantify your gross profit margin.
Gross Profit Margin = (Net Sales – COGS) / Net Sales
30% = ($300,000 – $210,000) / $300,000
Industry Averages for Gross Profit Margins
One of the difficulties in determining whether or not your business has achieved a good gross profit margin lies in how much variance occurs across different industries. While the overall average sits above 30%, there is a wide disparity in gross profit margins between regional banks (99.75%) and automotive businesses (9.04%), for example.
Generally speaking, service industries that do not sell physical products will post higher gross profit margins because they have a much lower COGS. A lawyer or consultant will not have as many necessary expenses to meet when providing clients with their “goods.” In contrast, manufacturing and food vendors must factor in higher upfront costs for equipment and raw materials to deliver purchasers a finished product.
Using your specific industry as a baseline will help determine whether your business has achieved a comparably good gross profit margin. Here are some averages for different sectors as of January 2021, along with their net profit margins (which will be explained further below):
|Industry||Gross Profit Margin||Net Profit Margin|
|Auto and Truck||9.04%||1.4%|
|Packaging and Container||22.39%||2.98%|
|Restaurants and Dining||27.60%||5.69%|
*Total Market calculations include industries not shown.
The Big Three: Gross Profit, Operating, and Net Profit Margins
The significant fluctuation between gross profit margin and net profit margin shown within many industries demonstrates how gross profit margin only comprises part of the picture. To holistically evaluate your business’ financial health and competitiveness, you will have to assess additional metrics in conjunction with gross profit margin.
Determining your operating and net profit margins will help complete portions of your puzzle:
- Operating Margin – Business expenses exceed the cost to produce and sell goods. You likely have employees whose wages do not factor into production cost (e.g., sales staff, executives, marketing). What do your facilities (e.g., offices, storefronts/showrooms) cost to run? All of these expenses affect your operating margin calculation:
Operating Margin = (Net Sales – COGS – Operating Expenses) / Net Sales
- Net Profit Margin – Net profit factors even more expenses into the equation, covering any costs unrelated to the business’ core operations. You must subtract taxes; gains or losses from investments and shareholders; and large, one-time transactions (e.g., acquiring/selling a part of the business’s property or product lines) as well before you arrive at your net profit:
Net Profit Margin = (Net Sales – COGS – Operating Expenses – Additional Gains or Losses) / Net Sales
None of the three metrics provide enough information on their own to declare your business a success or concern. A company could post incredible gross profit margins but see most of those percentage points whittled away by remaining operational expenses. One year’s net profit margin could reveal itself as an outlier if the business posted a massive gain or loss by selling or purchasing a physical location.
Collectively, however, you can look at all three margins to determine your business’ overall outlook.
Using and Improving Gross Profit Margin
Once you have determined your business’ gross profit and other margins, you can begin identifying areas to optimize your operations. As general gross profit guidelines, remember:
- Low percentages do not create cause for concern on their own, but do require higher sales volume.
- New businesses may have better percentages before needing to scale production and services.
- Some businesses use “loss leaders” with very low or negative gross profit margins on the individual products to lead customers to purchase more goods and services.
- Comparing gross profit margins with competitors can help you figure out how much of your costs you can pass on to customers before they begin looking elsewhere.
- Some companies, such as Apple, tier their offerings to usher customers to purchase products with better gross profit margins.
Finishing the Puzzle with CFO Hub
If you’re having trouble piecing together your gross profit margins or you’re seeking additional advice on where to target improvements for measured growth, perhaps you require some expert assistance.
For that, CFO Hub is here to help.
From reporting, accounting, and financial consultation to contracting a CFO for your business, CFO Hub can guide you through all of your pecuniary puzzles. With actionable insight from a dedicated team of experts, we can place all the pieces properly and master your margins together.
Ready to learn more? Reach out to us today.