Is your business making a sufficient gross profit margin? Do you know what your gross profit should be in order to pay overhead expenses and leave an adequate net profit? If not, you should develop a profit plan for your company.
TL;DR (Too Long; Didn't Read)
Gross profit margins vary by industry. A good gross profit margin is enough to cover overhead and leave a reasonable net profit.
What Is a Gross Profit Margin?
The basic structure of a company's profit and loss statement is as follows:
Sales minus cost of goods sold = gross profit
The cost of goods sold is the total cost of labor, materials and manufacturing overhead consumed to produce a product. Gross profit less general and administrative overhead expenses equals operating profit before taxes. Subtracting all taxes leaves net profit.
An Example of a Gross Profit Margin
Suppose Hasty Rabbit Corporation, a sneakers manufacturer, had total annual sales last year of $985,000. The cost of goods sold was $591,000. Using the formula: sales minus cost of goods sold = gross profit:
$985,000 minus $591,000 = $394,000 gross profit
As a percentage, gross profit margin or the gross margin ratio = gross profit divided by sales.
In our example: $394,000 divided by $985,000 = 0.40, or a gross profit margin of 40 percent.
Is a 40 percent gross profit margin good for the Hasty Rabbit Corporation? It depends.
What Is a Good Gross Profit Margin?
Gross profit margins vary by the type of industry. A gross profit margin that is sufficient for one industry may be woefully poor in another. In general, companies that manufacture products using labor and materials have higher gross profit margins than businesses who buy and sell merchandise, such as retailers and wholesale distributors.
This doesn't necessarily mean that manufacturers are more profitable. Gross profit margins are just one measure of financial performance. Operating profits and return on capital are more critical metrics of financial results.
Let's compare the gross profit percentages for a few industries. All figures will be stated as a percentage of sales for consistency.
What Is the Average Gross Profit Margin for a Manufacturer?
As an example, a manufacturer of electrical equipment has an average gross profit margin of 35 percent. Administrative wages run about 8 percent, and net profit averages 7 percent. These figures are typical for most types of manufacturers.
What About the Gross Profit Margin for a Retailer?
Let's start with grocery stores. They have gross profit margins in the range of 26 to 30 percent and a net profit margin that has averaged 2.3 percent in recent years. Their highest single expense other than cost of merchandise is wages, at 10 percent. Rent is around 2 percent of sales.
While the net profit margin for grocery stores may seem low, remember that their business is buying merchandise at wholesale prices and reselling at a markup. The inventory turnover rate for a grocery store is very high compared to other industries, so their total sales are equally high. As a result, grocery stores still earn a respectable 18 to 20 percent return on net worth.
Clothing retailers have higher gross profit margins in the range of 48 to 50 percent. They need high price markups because they frequently have to put their merchandise on sale with discounts from 20 to 50 percent off the full price.
What Is the Gross Profit Margin for a Restaurant?
Full-service restaurants have gross profit margins in the range of 35 to 40 percent. As a rule of thumb, food costs are about one-third of sales, and payroll takes another third. Net profit margins are from 3 to 5 percent. A well-managed restaurant might net closer to 10 percent, but that's rare.
Business owners start out by designing a plan that details how they intend to make a profit. This includes determining a good gross profit margin for their industry that is sufficient to cover general and administrative expenses and leave a reasonable net profit.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.