Your gross profit margin is a critical key performance indicator for overall net profit. Yet is is misunderstood by some small business owners.
Your gross profit represents what you have left over from sales (revenue) after you take out the variable costs – those that increase or decrease based on sales volumes. These are often referred to as cost of goods sold (COGS) or cost of sales — and it applies to all businesses.
- If you sell products, like retailers or distributors, your variable costs include inventory.
- If you make products, like manufacturers, your costs include raw materials and labor associated with production.
- If you sell services, the costs include the labor associated with service delivery and may also include supplies required to do this.
Do you know your gross profit margin and how it compares to your industry? If not, take a few minutes to calculate it – divide your gross profit dollars by the sales/revenue for the same period. Please note that some small businesses include the above costs with expenses (versus the cost of goods sold). Talk to your accountant to make sure your costs are set up appropriately.
Demonstration: Markup Vs. Margin
Are you surprised? Many small business owners are. And here’s the most common reason why. They use markup to calculate the selling price and assume the markup percentage is their gross profit margin. Ouch. They are not the same.
In fact, if you mark up your products or services 30%, your gross profit margin on this product or service is actually 23.1%. Below is an example to demonstrate this.
- Your cost for your product or service is $100
- You mark it up 30% so your markup (or gross profit $) is $30
- Your selling price (cost + markup) is then $130
- Your gross profit is $30 – note the markup dollars and gross profit dollars are the same
- But, your gross profit margin (gross profit $ / selling price) is 23.1%
I am not an advocate of using markup exclusively to establish selling price because it often ignores things like value and competition. But if you do use this method, be aware of the difference and start backward. Determine your DESIRED gross profit margin, then calculate the selling price required to achieve it.
BONUS: For a quick markup and margin calculation and conversion tool, click here.
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