How to Figure Gross Profit Margins
The key to any successful business is its profit margin. Businesses that cannot generate a profit are not sustainable for any length of time. To determine a business's profitability, financial analysts will measure its gross profit margin as well as many other key financial aspects. The gross profit margin is calculated by subtracting the cost to produce the goods sold from the net sales numbers. It is expressed as a ratio.
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Things You'll Need
- Gross sales figures
- Cost of goods sold figures
- Discounts and returns figures
- Calculator
Instructions
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Determine net sales. Taking the gross sales number for a specified period and subtracting any discounts or returns calculates the net sales number. Most often, this number is analyzed on a monthly, quarterly and annual basis. For example, assume that a company has had $1,000 in gross sales for the month of January and $250 in returns and discounts. To calculate the net sales for this month, subtract $250 from $1,000. The net sales number is $750.
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Determine the cost of goods sold. This number takes into account the purchase of raw materials and labor costs associated with producing the goods that were sold. For the same example above, the cost to produce enough products that netted $750 in sales cost the company $300 to make. Simply subtract the cost of goods sold from the total net sales in order to determine the gross profit margin: $750-$300=$450. Thus, the company earned $450 in the month of January in profit.
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Understand what gross profit margin actually means. While the company earned $450 in profit from its business operations, it does not automatically mean that it has $450 in the bank free and clear. There are many other expenses associated with running a business that must be paid out of this number. A positive gross profit margin indicates to a financial institution that the company has the potential to be profitable, but it is how this number measures against other profitability ratios that provides the real picture of a company's financial health. Ultimately, the net profit number, or the bottom line, is the true measure of how efficiently a company utilizes its cash flow.
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