In a world where data is everything, controllers and CFOs play a role in shaping the company mission. This may involve a variety of key performance indicators (KPIs), including gross profit margin. This figure can provide an idea of a company’s overall efficiency and may be useful in shaping decisions regarding pricing and production costs.
Just how important is gross profit margin? Learn more about how this metric is calculated and what it might mean for your organization.
What Is Gross Profit Margin?
Gross profit margin refers to the money remaining from product sales after companies subtract the cost of goods sold (COGS). This figure, expressed as a percentage, reveals how much of your profits are used by the cost of producing the items you’ve sold.
Since no company can achieve perfect efficiency, the gross profit margin will never reach 100%. For instance, if you sell a product for $50 but it cost $20 to produce, your gross profit margin will be 60%.
Why Gross Profit Margin Matters
What exactly can gross profit margin tell you? There are several things that your gross profit margin might reveal.
Efficiency of Supply Chain
A low profit margin might indicate inefficiencies in your supply chain. That includes the cost of materials used to produce your products as well as problems and delays in distribution and delivery. Companies might use these figures to opt for a different production system or automate aspects of the supply chain to cut costs and boost efficiency.
Quality of Products
An unusually high gross profit margin might sound appealing, but it may reveal that your company is producing inferior products. Why? Customers may be willing to purchase goods at a competitive price, but your high margin may reveal that you’re using inferior materials or production methods, which can undermine customer loyalty long-term.
Your gross profit margin will also reveal the effectiveness of your pricing structure. Companies may choose to go for a low profit margin in order to outperform competitors in terms of sales volume.
Alternatively, companies may use these metrics to deliberately raise prices — intending to position their product as a “high-end” or luxury good in the consumer marketplace.
Comparison to Industry Benchmarks
Your company’s gross profit margin can also help you compare your organization to others in your industry. By comparing your gross profit margin to industry benchmarks, corporate leadership can determine whether your production or pricing models are effective and competitive.
How to Calculate Gross Profit Margin
Gross profit margin is a measurement of your profits after deducting the cost of goods sold (COGS). You can calculate this figure with a simple formula:
Gross Profit Margin = (Net Sales – COGS) / (Net Sales)
For example, imagine that your company brings in $12,000 in net sales, but it costs $8,000 to produce and distribute those goods. Using the above formula, your gross profit margin can be calculated as follows:
Gross profit margin = ($12,000 – $8,000) / ($12,000)
Gross profit margin = 33%
There’s no true “ideal” gross profit margin, since it may depend on a company’s goals and sales strategy.
Companies that aim for high sales volume can often afford a lower gross profit margin, as they earn revenue through the sheer number of sales. But other companies might rely on a higher sales volume coming from the sale of a smaller number of luxury or high-quality items.
How to Improve Gross Profit Margin
Unless you can increase your sales volume, a low gross profit margin may make it a challenge for your business to generate a profit. Companies can increase their gross profit margin in one of two ways.
Reduce Overhead Costs
First, businesses might look for ways to reduce production or distribution costs. Finding new suppliers, for instance, can help you lower the physical cost of manufacturing each product.
Automating your supply chain can also help you lower the cost of distribution and delivery — this change often has the added benefit of getting your products to your customers even more quickly.
Businesses can also raise prices to boost their profit margin. Admittedly, this can be a risky move, especially in a competitive industry. But as noted, some businesses actually use higher prices as a marketing tool, positioning their products as a high-quality alternative to the “bargain” options offered by competitors.
This decision should always be evaluated alongside other considerations, such as sales volume and sales strategy.
Gross Profit Margin and Corporate Strategy
Controllers and CFOs can use gross profit margin to guide corporate strategy. These figures provide a glimpse into an organization’s overall efficiency as well as its price structure.
The informed input provided by controllers and CFOs can then trickle down into marketing strategies and expectations for sales volume. It can also help decide when and how to automate core processes to save time and money.
Check out the other KPIs in our series below:
Revenue Growth Rate