Gross profit margin is a common measure of how well a business is doing. It is defined as the proportion of sales revenue a business earns after deducting the costs of production or sales, such as raw materials, parts and labor. Businesses can use these figures to help determine the optimal sales price for a product, keeping in mind that higher prices tend to make any product less competitive.
Tip
The gross profit margin in dollars is calculated by subtracting the cost of goods sold from total sales revenue. To estimate your product's sales price necessary to support a certain targeted gross profit margin, you must first figure out the total amount revenue necessary to support that margin. Then, divide revenue by the number of units you plan to sell to find the price that will support your desired gross profit margin.
What Does Gross Margin Show?
Gross profit margin represents dollars, while gross profit margin percentage expresses those dollars in percent terms. It's simply the amount of sales revenue a business has left after subtracting the cost of goods sold (COGS). COGS includes all of the costs directly attributable to producing a certain product, such as the cost of inventory for resale, raw materials in the case of a manufacturing firm, parts and labor. Indirect costs such as rent, taxes, insurance and wages paid to employees not directly involved in production are shown in a separate category on the income statement, called selling, general and administrative costs.
Doing the Math
The gross profit margin in dollars is calculated by subtracting the COGS from total sales revenue. To figure the gross margin percentage, divide the dollar result by total revenue. For example, if a company has $100,000 in revenue and its COGS is $40,000, its gross profit margin is ($100,000 - $40,000) = $60,000. Dividing this result by the $100,000 revenues equals 0.6 or 60 percent. This represents the company's gross profit margin percentage and shows that the company keeps 60 percent of its sales revenue after paying its COGS, or the costs to produce its products.
Estimating Gross Sales and Targeted Margin
To estimate your product's sales price necessary to support a certain targeted gross profit margin, you must first figure out the total amount revenue necessary to support that margin. Subtract your desired gross profit margin percent from 100 percent, since you don't yet know your actual sales number. For instance, if you choose a gross profit margin of 60 percent (0.60), your calculation result is 40 percent, or 0.40. This means that you expect 40 percent of each sale to go to COGS.
Next, divide your actual or estimated COGS, in dollars, by the result of the first operation. For example, if your COGS are $40,000 for the year, and the result of the first operation, your required COGS percent, was 0.40, you would need $40,000 divided by 0.40, or $100,000 in revenue to reach a profit margin of 60 percent (0.60).
Calculating Your Per-Unit Sales Price Target
Your total sales revenue equals the quantity of a product sold times its sales price. After calculating the total amount of revenue necessary to achieve your desired gross profit margin, divide revenue by the number of units you plan to sell to find the price that will support your desired gross profit margin. For example, from the example above you've determined that, based on your actual COGS of $40,000, you'd need at least $100,000 in sales to support a 60 percent gross margin. You also want to move 800 units of your product in your first year. Calculate your target unit sales price as follows:
$100,000 gross sales / 800 units sales goal = $125 targeted sale price per unit
It's worth noting that your company may not actually be able to sell the necessary quantity at that price level. The business managers must now decide what actual price to charge given various factors, including market competition, seasonality, and the fact that higher prices can sometimes dampen sales. Additionally, if the price is too high for the current market, it's worth also examining COGS for opportunities to reduce the costs to produce the product.
