How to Calculate Gross Profit Margin (With Example)

You may already be familiar with gross profit, or the amount of money a business has left over after paying all direct expenses related to manufacturing a product or providing a service. (In simple terms: Revenue minus cost of goods sold.) But what is the gross profit margin?

Gross profit margin is the percentage of your business’s revenue that exceeds production costs. In other words, it’s the percentage of the selling price left over to pay for overhead expenses.

Higher gross margins mean more money left over to cover operating expenses.

Both gross profit and gross margin are key metrics business owners should continually review to remain profitable.

Here’s What We’ll Cover:

What Is Gross Profit Margin?

How to Calculate Gross Profit in Dollars

How to Calculate Gross Margin/Gross Profit Margin

What Is a Good Gross Margin?

How to Calculate Gross Margin for a Service-Based Company

The Relationship Between Gross Profit Margin and Net Profit Margin

Why Should You Calculate Operating Margin?

What Business Has the Highest Profit Margin?

NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice, please contact an accountant in your area.

What Is Gross Profit Margin?

Gross profit margin shows whether a company is running an efficient operation and how profitably it can sell its products or services. It is also known as gross margin.

The term “profit margin” by itself may refer to any of the following margins. Each weighs the cost of doing business with or without certain expenses:

• Operating profit margin: Calculated without interest or tax
• Pre-tax profit margin: Shows profit before tax is deducted
• Net profit margin: Considers all expenses related to the production of a product; it’s also known as the “bottom line”

How to Calculate Gross Profit in Dollars

You can calculate gross profit in dollars using your income statement with the following formula:

Let’s use an example to calculate the gross profit and the gross margin.

Tina’s T-Shirts is a small business that has been open for about a year. Tina wants to get a better idea of how expenses are affecting her company’s profit. So, she opens her accounting software and starts making some calculations.

Her total revenue from sales is $400,000 for the year.

Her cost of goods sold is $325,000. The cost of goods sold includes the labor costs, the cost of raw materials, and manufacturing overhead costs to produce the products that she sold. In other words, “direct costs.”

To calculate gross profit in dollars, she would do the following calculation:

$400,000 – $325,000 = $75,000

This means Tina has generated $75,000 in gross profit.

How to Calculate Gross Margin/Gross Profit Margin

When you want to look at your gross profit margin, you’ll want to calculate a percentage.

Calculate gross profit margin after first calculating gross profit, and then applying this formula:

Continuing with the the example of Tina’s T-Shirts, the gross margin calculation is:

($75,000 ÷ $400,000) x 100 = 18.75%

Tina’s T-Shirts’ gross profit margin is 18.75%.

What Is a Good Gross Margin?

In the example above, Tina is wondering if 18.75% is adequate. Should she be doing better? There are two considerations she needs to weigh.

Gross Profit Margins Are Industry-Specific

A high profit margin is one that outperforms the average for its industry. According to CFO Hub, retailers’ average gross profit margin is 24.27%.

This means Tina’s business is doing a little below average, with an 18.75% gross profit margin. She might consider raising her prices or looking for ways to reduce direct costs without cutting quality.

Gross Profit Margin Is Variable

Profit margins for a startup are generally lower because the operation is brand new, and it typically takes a while for efficiencies to develop.

Since it’s Tina’s first year in business, she doesn’t need to panic that her gross profit margin is a little below average.

However, she may be able to improve efficiencies and perhaps realize higher profits. Lately, she has been thinking of expanding her line of clothing, too.

First, she needs to consider how spending money on labor and manufacturing to provide these new products will affect her gross margin.

She might produce a small batch of the new clothing and see how those items sell. Then run the numbers again to determine if the new clothing lines are profitable and can be permanent additions to her company.

How to Calculate Gross Margin for a Service-Based Company

Let’s assume Peter owns a landscape business. This year he generated $250,000 in revenue. He has no cost of goods sold because he’s not selling a product. He provides a service for cutting customers’ lawns, trimming bushes and trees, and clearing lawn litter.

Without any cost of goods sold to subtract, Peter’s gross profit is the same as his total revenue: $250,000. And his gross margin percentage is 100%. All of his revenue is available to pay for his administrative expenses.

Since Peter’s gross profit margin is 100%, he needs to keep a close eye on his net margin (his bottom line after accounting for operating expenses) to ensure his company remains profitable.

The Relationship Between Gross Profit Margin and Net Profit Margin

Monitoring your gross margin is vital to ensure your business is generating enough revenue for sustainability. But the net profit margin is the most definitive measure of a company’s profitability.

That’s because the gross profit margin doesn’t account for important financial considerations like administration and personnel costs. If not managed properly, these indirect costs can really eat into a company’s profit.

And if you’re looking to secure financing from a bank or are considering bringing on a business partner, the bottom line (net margin) will be what is important.

Why Should You Calculate Operating Margin?

Calculating gross margin allows a company’s management to better understand its profitability in a general sense. But it does not account for important financial considerations like administration and personnel costs, which are included in the operating margin calculation.

If not managed properly, these indirect costs can really eat into a company’s profit. Often administration and personnel costs are where management will make their first cutbacks because those types of reductions will not affect a company’s core operations, which are vital to the survival of a business.

What Business Has the Highest Profit Margin?

Businesses with high gross margins are usually service-oriented businesses. As we saw in Peter’s landscape business, this is because they don’t have any (or many) cost of goods sold—the direct costs associated with manufacturing a product.

Why do some businesses manufacture products when service-based businesses enjoy more profits? Well, if the business is large enough, it can benefit from economies of scale, a phenomenon where the average cost of goods sold decreases with an increase in output.

According to IBIS World data, some of the industries with the highest profit margins include software developers, industrial banks, and commercial leasing operations.

Low profit-margin industries include grocery stores, construction companies, and publishers.

When looking at your gross margin, benchmarking against averages in your industry gives you a more accurate picture of how you stack up relative to competitors.

New and startup business owners need to monitor their company’s finances closely. Looking at your gross profit margin monthly or quarterly and keeping track of cash and inventory will help optimize your company’s performance.

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