What is a good profit margin?
Anotoine de Saint-Exupery once famously said, “A goal without a plan is just a wish.”
This statement has held up true over time. This statement can apply to multiple areas in the business environment. Product development, marketing, expansion—you name it.
If an actual plan isn’t in place, the goal is not likely to happen.
This is appropriate when it comes to gross profit margins. To understand whether the gross profit margin (GPM) for a company is good, there must be something to measure against. Thus, the goal.
A company needs a good GPM to set prices, manage expenses, and ensure health cash flow in the future. The GPM is vital for all industries.
In this post, we will discuss gross profit margin. We will explain how to identify a good gross profit margin. We will discuss ways to improve profitability. Additionally, we will provide an example of identifying weaknesses in the cost of good sold.
What is gross profit margin?
Gross profit margin is the calculation of total net revenues less the cost directly associated with generating those revenues. The formula is: net revenue minus cost of goods sold equals gross profit margin.
The gross profit margin represents the funds left over to cover operating expenses and the expected net income.
Profit margins are key to successful businesses. This is true whether you are a large corporation or a small business owner.
Calculation of GPM
The most basic formula for calculating GPM is:
The information for revenue is usually straight forward. The revenue information comes from the sales journal module in the company’s accounting system. The more difficult part of the calculation comes from producing the correct cost of goods sold (COGS) number.
Generally, cost of goods sold is consists of three primary areas:
The calculation of the direct materials and direct labor costs are straight forward. They reflect the cost that the company can directly link to production costs. The more difficult item is the overhead or indirect costs.
Overhead costs are expenses needed to keep making the product or providing the service.
These costs cannot be directly traced to a specific item or serviced sold. Indirect costs typically include the utilities and rent for the production warehouse or software fees for a service organization.
You must account for and allocate these costs to cost of goods sold, or inventory for physical products. Without accurately allocating indirect costs, the company cannot determine the correct break-even point or calculate a precise gross profit margin.
What is a good profit margin?
As noted earlier, the way to determine a good gross profit margin on a product or service is to understand the company’s goal. More specifically, the company’s goal for net income. Generally, the flow of information on the income statement looks like this:
In this example, if the gross margin doesn’t cover operating costs, the company will have negative net income.
No company wants to end the year with negative net income.
Another way to think of whether the GPM is good, is to flip the formula around. For example, lets assume a company wants to have $250,000 of net income for the year. Management understands that operating business expenses make up approximately 40% of total sales. With this knowledge, they can determine a suitable gross profit margin.
Now this example is for demonstration purposes. The actual calculation will incorporate many factors such as variable costs in the operating expenses, industry norms, etc.
However, the overall concept is still the same. In order to reach the target income, the profit margin needs to cover all business expenses and have extra money left over. This extra money is necessary to meet the goal.
Efficiencies in GPM
Calculating the dollar amount in the GPM is only half of the GPM consideration. The other half is the gross profit margin expressed as a percentage (GPM%). The formula for GPM% is:
The calculation of the percentage allows a company:
- To compare their percentage to the industry average.
- To determine if we can gain any efficiencies.
In this example, we have made up a SaaS company and compared their GM% to the industry average in January 2020. As you can see, this fictitious company has a lower gross profit margin then the industry average.
Suggestions management can do to improve their gross profit margin.
- The first is examine pricing strategies of their services. This could work for small companies, but if they already have similar prices to their competitors, it won’t be an option.
- The other area is to increase efficiencies. If the GMP% is lower than the industry average, then that usually indicates inefficiencies in the production process. In other words, how can management reduce the cost of goods sold and still have the same revenue?
- Management can evaluate what can be streamlined and ensure that work is being done at the right rate. For example, is a first-year employee or a seasoned employee doing some of the more basic tasks? Proper leveraging in the servicing-based industries will help with efficiencies.
Tips and Reminders
When determining what is a good gross profit margin, remember the following:
- First, know the company’s net income goal. Then, determine the amount of operating costs required to achieve that goal.
- Verify the cost of goods/services calculation includes direct materials, direct labor, and overhead.
- Compare GPM% to industry averages.
- Determine if we gain efficiency in the cost of goods/services area.
Conclusion
Planning out where the company wants to be is vital in determining whether there is a good gross profit margin.
Does your company need assistance in budgeting, forecasting or financial strategy? Please contact one of our CPAs today for a free consultation and we will help guide your company towards its goals.