If you do not know what your gross profit margin is how do you know whether you are making enough money to cover your overheads, tax and make a profit to pay yourself?
Far to often we are coming across businesses that are basing their sales price on what they see as the existing market rate set by competitors. What are your competitors gross margin %, overhead costs and payroll costs? Don’t know? If that is the case how can you decide to charge the same price as them?
Below we will introduce how to calculate the gross profit margin to help you understand how important it is to your business. To make this easier we are going to introduce a worked example. Company A sells widgets at a price of £100 with cost of goods sold of £65.
Sales price – cost of goods sold = gross profit
£100 – ££65 = £35 gross profit
Simple. The amount of money you make on a product or service after paying for the cost of goods sold (variable and fixed costs linked directly to the sale). The cost of goods sold could contain many different things and could vary business by business so if you are comparing yourself to competitors take this in to consideration. It does not include items such as office expenses, rent and administrative costs.
Gross profit / sales price x 100
£35 / £100 x 100 = 35%
Your gross profit % can be used as a measure of how efficient you are i.e. the higher the gross profit (£35) the more profit you are making per £1 of input (cost of goods sold – £65) the more efficient your business is. The larger your gross margin the more opportunity you have of paying those overhead and fixed administrative costs and of course making a profit.
Now that you know your are making £35 per widget what are you going to do with this new found knowledge? If I were you I would think about:
- What are my competitors gross profit margins and how can I use this information to gain a competitive advantage (gross profit margin is only one metric to measure yourself against other businesses).
- Make comparisons against other periods of time. Are you doing better or worse than last month, last quarter or last year?
- Compare the gross profit margin against other products or services that you sell, should you concentrate more resource into selling widgets. Are all products profit making?
- Use this statistical information to review, refine and improve the widget making process and be more efficient.
- Investigate areas when the gross profit margin has dropped to see if your stock control process is correct, are your purchase order processes robust, are price variances on cost of goods sold being investigated.
No. If I sell one widget and I make £35 gross profit and my gross profit margin is 35% how much gross profit should I make if I sell 100 widgets?
100 widgets x £35 = £3,500 gross profit
£3,500 / £10,000 (100 widgets x £100) x 100 = 35%
If you sell more at the same price with the same cost of goods sold then your gross profit margin should not change. If it is different then something has changed and it needs to be investigated. These could be:
- poor stock control
- incorrect closing stock figures
- incorrect record keeping
- increased cost of goods sold
- suppliers overcharging
- timing differences
- discounted sales prices
- supplier bulk purchase discounts
The list could go on but hopefully this gives you a flavour.
Now that you know your cost of goods sold is £65 per widget you can use this information to help you decide on a selling price for your widget for a given gross profit margin of say 55%.
Sales price = £65 / (1-55%) = £65 / 0.45 = £144.44
You now know that in order to achieve a gross profit margin of 55% you need to sell your product at £144.44. Great. Now you need to look at what else is in the marketplace and review whether your widget would sell at £144.44 per item. If not then you need to look at you overheads and your cost of goods sold. Can you make the same gross profit margin charging a smaller amount if you can reduce the amount of money you are spending on overheads and cost of goods sold.