By Jack Perkins, founder at CFO Hub, which provides on-demand CFO, controller, accounting, and HR services.
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Gross profit margin is one of the most crucial barometers of your company’s financial health and competitiveness within its industry—specifically, it helps you evaluate your production efficiency against competitors’.
GPM shows the money you made after paying the direct costs of running the business (i.e., the costs of goods sold). Typically, it’s shown as a percentage of net sales.
At the very least, a company’s gross profit margin should reach the point where revenues cover production costs. But this is only the minimum threshold business owners should target. If your GPM fails to achieve this baseline, drastic changes need to be made—and soon.
What, then, is a healthy gross point margin?
The answer depends on your industry, so we’ll look at some different baselines after breaking down GPM calculations.
Calculating Gross Profit Margin
Gross profit margin indicates a company’s sales performance based on the efficiency of its production process or service delivery. It’s calculated by subtracting direct costs from revenue, dividing that figure by revenue and then multiplying by 100.
The formula for gross profit margin looks as follows:
GPM = [(Revenue – COGS) / Revenue] x 100
As an example, let’s peruse some data from a fictional apparel retailer’s income statement:
• Revenue: $500,000,000
• Cost of Goods Sold (COGS): $250,000,000
(Revenue – COGS) = $500,000,000 – $250,000,000 = $250,000,000
[($250,000,000) / $500,000,000] = 0.5
0.5 x 100 = 50% GPM
Dividing $250 million by $500 million shows that 50¢ is generated on every dollar of revenue. Multiplied by 100, your GPM would be 50%.
It’s important to remember that GPM conveys how much revenue your products or services generate per dollar after subtracting your cost of goods sold, so it only factors in the direct cost of sales. Other operating expenses—such as rent, payroll, marketing and taxes—are not included.
Therefore, its primary use case is to assess the performance of individual goods and services.
What’s A Good Gross Profit Margin To Target?
Gross profit margin is a relative figure. As a result, comparing it across industries is generally unhelpful since there’s so much variance. Instead, it’s more useful as a performance benchmark for measuring your business against competitors within the same space.
Per the Bank of Canada, a 50% GPM would be close to the industry average within retail apparel. However, it would be calamitous for tech or finance, which typically report a gross profit margin in the 80% to 90% range.
So, what are some other industry averages you can gauge your business against?
According to data collected by New York University in January of 2022, the average GPMs for the following industries are:
• Advertising: 26.2%
• Apparel: 53.04%
• Banks (regional): 99.83%
• Construction/Engineering: 13.45%
• Financial services: 85.08%
• Hospitals/Healthcare facilities: 36.78%
• Real estate (development): 28.92%
• Retail (general): 24.32%
• Retail (online): 41.54%
• Software (internet): 61%
Your industry standard is the first comparative measurement you should consider when determining your GPM’s strength—but it’s not the only one. You should also factor in:
• Year-on-year GPM movement. By comparing your current and prior year income statements, you can see whether your gross profit margin increased or decreased. Generally speaking, it’s ideal if your GPM improves annually.
• Specific competitors’ GPM. Evaluating your competitors’ GPM lets you know how much more or less efficient your business operates. This can tell you how much cost can be passed on to consumers before they start shopping elsewhere or whether you can offer much better pricing after identifying and resolving inefficiencies.
• Loss leaders. In some instances, you may provide products or services that purposefully maintain a low (or even negative) gross profit margin to incentivize purchases on other items. Think Costco’s food court, with its $1.50 hot dog combos.
How Do You Increase Your GPM?
The gross profit margin equation is relatively simple. If you want to improve your GPM, you typically have one of two paths:
1. Increase prices
2. Reduce COGS
Depending on your business, either one of these measures—or even both—could dramatically improve your gross profit margin. But with either course, you must weigh your options carefully before taking decisive action.
Raising prices typically involves passing on the costs to the consumer. If you do that, it must be incremental or in line with competitors’ strategies. Even then, such an action could upset loyal customers and turn off prospective ones.
In most cases, reducing your COGS is the superior, albeit more difficult, option. Depending on your business, there may be several ways you can accomplish this, including:
• Automating processes
• Renegotiating with suppliers
• Finding new vendors
• Creating economies of scale
• Purchasing in bulk
• Substituting lower-cost materials (where possible)
• Offshoring manufacturing
• Eliminating poorly performing products
Leverage The Right Financial Metrics For Decision-Making
Gross profit margin is a significant metric of your business’s health and efficiency, yet it doesn’t paint a comprehensive financial picture. Although important, GPM is just one piece of the puzzle.
Put simply, it’s a useful tool to understand the profitability of individual goods or services, but not of holistic operations. And remember—it’s a comparative metric that must be considered in light of your competitors’ performance.
