## Key Profitability Ratio

Gross profit is one of the more important indicators of sales success and the overall financial well being of a company. After all, regardless of sales revenues, if there are no gross profits then the sale has little value. In fact, most companies measure their sales team’s success by the amount of gross profit generated per sale. So, what does it take to calculate gross profit? More importantly, how does one take the analysis a step further and decide on how to calculate a gross profit margin?

## Understanding Gross Profit & its Relationship with COGS

Before moving forward with calculating gross profit margins, it’s perhaps best to start by understanding what’s involved in calculating gross profit. In its simplest form, gross profit is the sales total, or revenue derived from sales, minus the cost of goods sold or COGS. When looking at the cost of goods sold, think of the material and labor costs to manufacture a given product. Another cost included in COGS is the freight cost to get those parts, or raw materials used in production, in and out of the warehouse. What’s not included in COGS? Well, it doesn’t count the salaries of the sales people selling the product or the miscellaneous support costs involved in sales.

- Gross Profit = Sales Revenue – COGS

## What Role Do COGS Play in Determining Gross Profit Margin?

The costs of goods sold also plays a role in determining how to calculate gross profit margin. In this case, the gross profit margin calculation involves taking the gross profit and dividing it by sales totals or sales revenue. While there are some variations on how the calculation is expressed, it still comes down to taking sales revenue minus COGS and then dividing it by sales revenues.

- Gross Profit Margin = Gross Profit / Sales Revenue

or

- Gross Profit Margin = Sales Revenue – COGS / Sales Revenue

## An Example of How to Calculate Gross Profit Margin

Let’s assume that a company had sales revenue of $40,000 and had COGS of $15,550 during a given quarter of its fiscal year. To calculate gross profit margin would involve taking the $15,550 of COGS and then subtracting from the $40,000.00 sales revenues. The resulting amount of $24,450 would then be divided by the original sales revenue of $40,000.00 and would then be turned into the gross profit margin, which would be 61%.

- Gross Profit Margin = Sales Revenue – COGS / Sales Revenue
- Gross Profit Margin = $40,000 – $15,550 / $40,000
- Gross Profit Margin = $24,450 / $40,000 or 61%

## Gross Profit Margin Percentages for Different Business Models

It’s important to note that not all industries, markets and business models will have similar gross profit margins. What might be considered too low for one company, might be high for another. For instance, certain distribution business models have lower overhead and as such, typically have lower COGS. For distributors, pricing is typically more aggressive and margins are consequently lower. However, this doesn’t necessarily mean the company isn’t doing well. Again, it’s all relative to the business model and the market the company operates in.

When looking at how to calculate gross profit margin, be cognizant of its importance relative to sales totals or revenue. However, don’t make the mistake of maximizing gross profit on each and every transaction. Instead, take a long-term approach and increase gross profit margins over time.

*Image Credit: **https://www.morguefile.com/archive/display/133001*