Gross profit margin:
what is left of each sale after direct costs

What gross profit margin shows

Gross profit margin is the share of your sales revenue that remains after you pay the direct cost of what you sold. That direct cost is called cost of goods sold, or COGS. What remains has to cover rent, salaries, marketing and tax before anything is left as profit.

It is the first health check for a product business. If the gross margin is too thin, no amount of cost cutting in the office will rescue the business, because the problem sits in the price or the buying cost.

You will also see it called gross margin. Gross profit is the rupee amount; gross profit margin is that amount as a percentage of revenue.

Use it for three decisions: whether a product is worth stocking, what price to charge, and whether a supplier's price rise can be absorbed. Service businesses use it too, treating the direct cost of delivering the service, such as contractor fees, as COGS.

Gross profit margin formula

COGS means costs that exist because you made or bought the item you sold. Typical items are listed below. Costs that would continue even if you sold nothing, such as office rent, are not COGS.

• Raw materials or the purchase price of goods for resale.
• Direct labour on production or packing.
• Packaging and inbound freight.
• Manufacturing costs directly tied to output, such as job-work charges.

1. 1Total your net sales for the period, excluding GST and after returns.
2. 2Total the direct cost of the goods you sold in the same period, not the goods you bought.
3. 3Subtract the second figure from the first to get gross profit.
4. 4Divide gross profit by net sales and multiply by 100.

Example: a clothing retailer's year

A retailer selling kurtas, dupattas and accessories wants to know how much of its year's sales are left after paying for the goods.

For every ₹100 of sales, ₹64 goes on the goods themselves and ₹36 is left to pay for the business. The blended figure hides differences between lines, so it is worth splitting it.

Dupattas bring in ₹3,50,000 but earn the lowest margin. If shelf space or ad money is limited, kurtas deserve it first.

Margins also move when buying costs change. If the same sales cost 5% more to source, COGS rises from ₹8,00,000 to ₹8,40,000, gross profit falls to ₹4,10,000 and the margin drops from 36% to 32.8%, even though nothing about the shop has changed.

Setting a price for a target margin

You can run the formula backwards to find the price that delivers the margin you want. Divide the cost by one minus the margin, written as a decimal.

Notice that adding 40% to the cost would give only ₹896, which is a margin of about 28.6%. A margin target and a markup target are different numbers; the markup guide on this site shows how to convert between them.

Real prices end at points such as ₹1,099 rather than ₹1,067. Round up when you can, then recheck the margin at the final price. A price that is rounded down gives away profit on every unit sold.

What discounts do to your margin

Discounts come straight out of gross profit because the cost of the item stays the same. A 10% price cut costs far more than 10% of your profit.

At 20% off, you must sell 2.25 times as many units just to earn the profit you made at full price. Before running a sale, check whether the extra volume is realistic.

A smaller concession often protects the margin better than a headline discount. Bundling two items, setting a free-delivery threshold or offering a gift at a minimum order value all raise order size without cutting the price of each item.

Reading the number and what to do about it

A gross margin is only good or poor relative to something. Compare it with your own previous months, with what the business needs to cover its overheads, and with other businesses that sell the same kind of product.

If the margin is lower than you need, there are only three levers. Raise prices on items where customers are not price-sensitive, negotiate or switch suppliers to bring COGS down, or change the sales mix towards higher-margin lines.

If the margin is falling over several months while prices are unchanged, look at supplier rates, wastage and discounts before blaming demand.

Mistakes that make gross margin unreliable

• Including GST in revenue. Tax collected for the government is not your income, so divide by revenue excluding GST.
• Forgetting returns and discounts. Use net revenue, otherwise the margin looks better than it is.
• Mixing overheads into COGS in some months and not in others. Decide your definition and keep it fixed.
• Ignoring stock losses. Damaged or unsold stock you write off belongs in the cost of what you sold.
• Comparing your margin with a different kind of business. A grocer and a jeweller work with entirely different margins.
• Using purchases instead of goods sold. If you bought a large batch of stock late in the year, matching it against sales that have not happened yet makes the margin look far too low.

Gross margin also says nothing about what the business keeps. A 36% margin can still lose money if rent, salaries and marketing add up to more than the gross profit. The net profit margin guide takes the next step by subtracting every other cost, including tax.