Gross profit equals your revenue in a period, minus your costs of goods sold. Your gross profit percentage, commonly known as gross margin, equals gross profit divided by revenue. It is a measure of your small business's ability to efficiently turn revenue into profit. A low gross profit means that relative to industry peers, you struggle to create profits on sales.
For a manufacturer, gross profits result when you sell goods for more than what cost you to make them. Materials, variable labor and equipment costs are examples of manufacturing cost of goods sold.
For resellers, gross profits result when you resell goods to consumers for more than they cost you to acquire them. Gross profits are necessary to earn bottom-line net profits; they must exceed fixed costs and any irregular costs during the period.
As an example of the gross margin calculation, assume a periodic revenue of $50,000, less cost of goods sold of $30,000, which equals gross profit of $20,000. Your margin is 40 percent. You don't really know whether this is relatively high or low until you compare it to industry norms. If it exceeds the average margins earned by competitors, you have a high gross margin. If your percentage is below those norms, your small business has a low gross margin -- a low gross profit percentage.
Gross margins vary significantly by industry, based on a variety of factors. In a purely competitive industry, margins tend to be smaller because you have more competitors beating down their prices to attract customers. Commodity-type products that are readily available are relatively hard to provide with value added.
Products that are more easily customized usually offer higher margins, because you can provide a better quality solution.
Your reaction to a relatively low gross profit percentage depends on the operations of your small business. As the top low-cost provider in your industry, it is generally expected that you would have lower margins. Your objective is to earn more net profits by selling greater volume than competitors that earn higher margins. If your margin is lower than companies that offer similar or below-par quality or value, you might need to address the issue.
Ways to optimize your revenue include increasing marketing or product development to better emphasize your quality, and avoiding excess buying of inventory. To reduce variable costs, negotiate better deals with suppliers, and eliminate waste in product manufacturing or acquisition. One or both of these maneuvers can increase your gross profit percentage.