Why Is the Gross Profit Margin Important to a Company?

Regardless of whether you are running a one-person operation or a multibillion firm, you must generate sufficient gross profits to survive over the long haul. While registering a gross profit is not enough for financial viability, it is a prerequisite. Therefore, it is critical to understand how gross profit is calculated, why it matters and what you can do to improve it.

Gross profit margin is a figure that expresses the percentage of sales the firm took in as profits before accounting for overhead expenses. Gross profit margin equals gross profit divided by revenue. Gross profit equals revenue minus cost of good sold. So, if a firm sold $1 million worth of merchandise and it cost $800,000 to manufacture the sold goods, gross profit equals $1,000,000 - $800,000 = $200,000. Gross profit margin, also known as simply "margin," equals $200,000 divided by $1,000,000 which is 20 percent. In other words, the firm retains 20 cents out of every dollar in sales after paying for the cost of the goods sold.

Gross profit only accounts for the cost of goods sold. Overhead costs, which are all costs associated with activities that do not go into manufacturing the finished product or delivering the service, must be subtracted from gross profits to arrive at net costs. Our imaginary firm with $200,000 in gross profits may have to pay for overhead costs such as registration fees with local authorities and advertising costs, leaving it with only $50,000 in net profits. Since you deduct further costs from gross profits, you cannot have a positive bottom line, if gross profits are not sufficiently large. Where gross profits are negative, net profit will certainly be a negative figure.

If the gross profit margin of a business is unsatisfactory, the reason is high costs, low average sales price or both. To reduce costs, you can train staff and implement better production techniques, lower material costs by buying in bulk or shopping around to find lower prices for major inputs, or employ cheaper personnel.

To increase average sale price, you can simply increase prices across the board. This is a risky move, however, as your gross margin might improve, while your bottom line takes a severe hit. If our firm were to raise prices and sell only $500,000 worth of goods that cost $350,000 to manufacture, gross profit will severely decline to $150,000 while gross margin will jump to 30 percent. Despite improving margins, the firm makes far less money. A less risky maneuver might be to reduce sales discounts, which also increase the net sales price.

When you evaluate the gross margin of a firm, keep in mind that what constitutes a healthy margin entirely depends on the industry and the unique circumstances of the firm in question. While jewelry retailers might enjoy an average margin of 30 percent, even the most successful food manufacturer may have to contend with high single digits. The firm's strategy also plays a key role. While it may be OK for a growing firm to cut prices and operate at a low margin to gain new customers, the same tactic might backfire for an established company.