- Virtual CFO Services
- Forensic Accounting
What is a good profit margin?
Anotoine de Saint-Exupery once famously said, “A goal without a plan is just a wish.”
This statement has held up true over time. When it comes to the business environment, this statement can be applied to multiple areas. Product development, marketing, expansion—you name it.
If an actual plan isn’t in place, the goal is not likely to happen.
This is appropriate when it comes to gross profit margins. To understand whether the gross profit margin (GPM) for a company is good, there must be something to measure against. Thus, the goal. Without a good GPM a company will fail to properly price their product, track their expenses, and ultimately impair their future cash flow. The GPM is vital for all industries.
In this post we will define gross profit margin, show how to determine a good gross profit margin, and provide an example of identifying inefficiencies in the cost of goods sold.
What is gross profit margin?
Gross profit margin is the calculation of total net revenues less the cost directly associated with generating those revenues. The formula is: net revenue minus cost of goods sold equals gross profit margin. The gross profit margin represents the funds left over to cover operating expenses and the expected net income.
Calculation of GPM
The most basic formula for calculating GPM is:
The information for revenue is usually straight forward. The revenue information comes from the sales journal module in the company’s accounting system. The more difficult part of the calculation comes from producing the correct cost of goods sold (COGS) number.
Generally, cost of goods sold is comprised of three primary areas:
The calculation of the direct materials and direct labor costs are straight forward. They represent the cost that can be directly traced to the production of the service or product sold to the customer. The more difficult item is the overhead or indirect costs.
Overhead or indirect cost are, generally, costs that were incurred and are necessary to continue producing the product or supplying the service.
These costs however cannot be directly traced to a specific item or serviced sold. Indirect costs typically include the utilities and rent for the production warehouse or software fees for a service organization. These costs must be accounted for and allocated to cost of good sold, or inventory for physical products. Without the proper allocation of the indirect costs, the company will not be able to determine the correct break even point and calculate an accurate GPM.
What is a good profit margin?
As noted earlier, the way to determine a good gross profit margin is to understand the company’s goal. More specifically, the company’s goal for net income. Generally, the flow of information on the income statement looks like this:
As you see in this example, if the gross margin is not sufficient to cover the operating costs then the company will have negative net income. No company wants to end the year with negative net income. Another way to think of whether the GPM is good, is to flip the formula around. For example, lets assume a company wants to have $250,000 of net income for the year. Management knows that operating expenses are around 40% of gross revenues, so from this information they can back into what would be a good gross profit margin:
Now this example is oversimplified for demonstration purposes. The actual calculation will incorporate many factors such as variable costs in the operating expenses, industry norms, etc. However, the overall concept is still the same. To achieve the planned net income, the gross margin needs to be sufficient to cover all operating costs with enough left over to meet the goal.
Efficiencies in GPM
Calculating the dollar amount in the GPM is only half of the GPM consideration. The other half is the gross profit margin percentage (GPM%). The formula for GPM% is:
The calculation of the percentage allows a company:
- To compare their percentage to the industry average.
- To determine if there are any efficiencies to be gained.
In the following example, we have created a fictitious SaaS company and compared their GPM% to the industry average (as of January 2020). As you can see, this fictitious company has a lower gross profit margin then the industry average.
Two things management can do to improve their gross profit margin.
- The first is increase the price of their services. This might be viable for smaller companies, however if this company already has similar prices as their competition then this will not be an option.
- The other area is to increase efficiencies. If the GMP% is lower than the industry average, then that usually indicates inefficiencies in the production process. In other words, how can management reduce the cost of goods sold and still have the same revenue? Management can evaluate what can be streamlined and is work being done at the right rate. For example, are some of the more basic items being done by a first-year employee or an seasoned employee? Proper leveraging in the servicing-based industries will help with efficiencies.
Tips and Reminders
- Understand the net income goal of the company and then determine how much operating cost need to be covered to achieve that goal.
- Verify the cost of goods/services calculation includes direct materials, direct labor, and overhead.
- Compare GPM% to industry averages.
- Determine if an efficiency can be gained in the cost of goods/services area.
Planning out where the company wants to be is vital in determining whether there is a good gross profit margin.
Does your company need assistance in budgeting, forecasting or financial strategy? Please contact one of our CPAs today for a free consultation and we will help guide your company towards its goals.