Understanding Gross Profit Margin

Importance of Gross Profit Margin

Earl Boyd teaches you how to calculate your 'Gross Profit Margin' and what it means to your business.

According to Jay Ebben, PH.D., one vital aspect that I often see entrepreneurs overlook in starting and managing a business is that of gross profit margin.

Gross margin (sales minus direct costs) is what is left over after costs associated directly with the sale of a product or service, such as materials and direct labor, are paid for. This is an extremely important number for every new and small business to manage, as it impacts both the likelihood of reaching breakeven and the amount of profit that is earned beyond breakeven. In other words, it directly impacts risk and return.

Gross Profit Margin Calculation Example

As a simple example of how gross margin affects breakeven and profit, consider a start-up with $300,000 in fixed overhead. If this firm's gross margin as a percent of sales is 50% (which means fifty cents out of each dollar in sales is retained in the company to cover fixed costs), it would need to reach sales of $600,000 to cover its overhead. If that same start-up were able to achieve a gross margin of 52% instead, breakeven would decrease by $23,000, or approximately 4%. The company would then begin earning a before-tax profit of fifty-two cents on each dollar in sales after revenues reach $577,000, rather than fifty cents on the dollar after $600,000.

gross profit margin formula

Managing gross margin helps a firm avoid problems with prices that are too low and direct costs that are too high, and hence problems with breakeven and profit. When a firm is generating adequate sales but gross margins are low, it signals an issue in one or both of these areas. One example of this is a newly-formed bakery that was losing money each month, even though it was quickly gaining a reputation for having the best tasting, most intricately decorated cakes in the area. This was a real problem since the bakery had already reached its production capacity and was turning away customers, but it still was not generating enough income to cover fixed expenses. A quick analysis revealed that gross margins were inadequate and that pricing was to blame: Though the bakery had higher quality cakes with more expensive ingredients, prices had been set at the level of the competition in fear of losing customers to lower prices. Considering that customers clearly perceived this bakery's cakes as better than the competition, that there was a waiting list of customers, and that most sales were for events such as weddings where customers are relatively price insensitive, it became obvious that prices needed to be raised.

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