How to Calculate Gross Profit Margin

A company's gross profit margin percentage is calculated by first subtracting the cost of
goods sold (COGS) from the net sales (gross revenues minus returns, allowances, and
discounts). This figure is then divided by net sales, to calculate the gross profit margin in
percentage terms.

What Does the Gross Profit Margin Tell You?

If a company's gross profit margin wildly fluctuates, this may signal poor management
practices and/or inferior products. On the other hand, such fluctuations may be justified in
cases where a company makes sweeping operational changes to its business model, in
which case temporary volatility should be no cause for alarm.

For example, if a company decides to automate certain supply chain functions, the initial
investment may be high, but the cost of goods ultimately decreases due to the lower
labor costs resulting from the introduction of automation.

Product pricing adjustments may also influence gross margins. If a company sells its
products at a premium, with all other things equal, it has a higher gross margin. But this
can be a delicate balancing act because if a company sets its prices overly high, fewer
customers may buy the product, and the company may consequently hemorrhage market
share.

Formula For Gross Margin & Gross Margin Percentage

To calculate gross margin, subtract the Cost of Goods Sold (COGS) from total revenue
and divide that number by total revenue (Gross Margin = (Total Revenue - Cost of Goods
Sold)/Total Revenue). The formula to calculate gross margin as a percentage is Gross
Margin = (Total Revenue – Cost of Goods Sold)/Total Revenue x 100.

1. Calculate the total amount in sales

Find the net sales revenue for the period you're measuring. The net sales come from the
revenue that all sales earn during the period, minus returns, discounts and any allowances
companies provide for products and services. As an example, assume a retail company wants to
calculate its gross profit ratio. Finance analysts calculate the net sales by subtracting the
returns and discounts during the period. If the company refunds $35,000 and discounts
$13,000 for the period and it has $210,000 in gross sales, this results in a net sales revenue of
$162,000. In the formula, this value substitutes as:

Gross profit percent = (gross profit ÷ $162,000) x 100

2. Determine the gross profit

The gross profit results from deducting the COGS from the net sales revenue a company
generates during a specific period. COGS typically accounts for labor, raw materials and other
direct expenses related to the production and sale of goods and services. For instance, in the
previous example of the retail company, the gross profit would equal the amount remaining
after subtracting COGS like inventory overhead, resale costs and labor from the net profit. If the
company's net profit is $162,000 and the COGS amounts to $75,000, the gross profit is $87,000.
Applying this value to the formula gives you:

Gross profit percent = ($87,000 ÷ $162,000) x 100

3. Divide gross profit and the net sales revenue and multiply by 100

Once you have the gross profit and net sales revenue, divide these values and multiply the
result by 100. This gives you the gross profit percent, which you can evaluate to determine
profitability. Using the example retail company, apply the formula when the gross profit is
$87,000 and the net sales revenue is $162,000:

Gross profit percent = ($87,000 ÷ $162,000) x 100 =

Gross profit percent = (0.54) x 100 = 54%
4. Evaluate the profit percentage

When you calculate the percentage, you can evaluate what the rate shows for your team or
business. For instance, in the example of the retail company, a gross profit margin of 54% can
indicate the company is allocating budget resources efficiently for generating sales. A lower
profit margin would indicate inefficiency in one or more areas of the production and sales
processes.
Gross margin vs. markup: how do they work?
Let’s take a closer look at the differences between gross margin vs. markup,
starting with margin.
To calculate gross margin, you must subtract the cost of goods sold from an item’s
sale price. For example, imagine that a product costs $50 to produce, and sells for
$80. This means that it has a margin of $30. Another option is to express this as
a percentage calculating margin divided by sales. The margin percentage is
therefore 37.5%.

By contrast, markup refers to the difference between a product’s selling price and
its cost price. It’s looking at the same transaction but from a different angle.
Using the same sale above, the item at a cost price of $50 is marked up by $30 to
its final sale price of $80. Expressed as a percentage calculated by dividing
markup by product cost, the markup percentage is 60%.

From looking at these two examples of markup vs. margin, it’s easy to see why the
terms are often confused. In terms of dollar amount, both the margin and
markup are $30. However, you can see that the markup percentage is higher than
the margin percentage.
The basis for the markup percentage is cost, while the basis for the margin
percentage is revenue. The cost figure should always be lower than the revenue
figure, so markup percentages will be higher than profit margins.

Markup vs. margin formula

We can express this basic concept in a markup vs. margin formula below:
Margin ÷ Cost of Goods = Markup Percentage

For example, if you want to earn a profit margin of $5 on a product with a cost
price of $8, you can plug these numbers into the formula to arrive at the markup
percentage:

$5 Margin ÷ $8 Cost = 62.5% Markup Percentage

You can then multiple the markup percentage by the cost price to arrive at a sales
price of $13.

You can also use these profit margin vs. markup formulas when expressing the
figures in percentages.

Profit margin percentage formula:

((Sale price – Cost price) ÷ Sale Price)(100)

Markup percentage formula:

((Sale price – Cost price) ÷ Cost Price)(100)

When to use markup vs. margin

If you want to decide on the right selling price to achieve a certain profit, you
should use the markup percentage as in the example below. However, if you’re
looking at performance, you’ll want to look at margins to assess past sales.
Choosing a markup percentage can be complicated. You should take various
factors including competitor costs, distribution, marketing, and the supply chain
to choose a reasonable value. By taking these factors into consideration, you can
ideally maximize profit.

What is a Trade Discount?

A trade discount is the amount by which a manufacturer reduces the retail price of a product when it sells to a
reseller, rather than to the end customer. The reseller then charges the full retail price to its customers in order
to earn a profit on the difference between the amount by which the manufacturer sold the product to it and the
price at which it then sells the product to the final customer. The reseller does not necessarily resell at the
suggested retail price; selling at a discount is a common practice, if the reseller wishes to gain market share or
clear out excess inventory.

The trade discount may be stated as a specific dollar reduction from the retail price, or it may be a percentage
discount. The trade discount customarily increases in size if the reseller purchases in larger quantities (such as
a 20% discount if an order is 100 units or less, and a 30% discount for larger quantities). A trade discount may
also be unusually large if the manufacturer is trying to establish a new distribution channel, or if a retailer has
a great deal of distribution power, and so can demand the extra discount.

A manufacturer may attempt to establish its own distribution channel , such as a company website, so that it
can avoid the trade discount and charge the full retail price directly to customers. This can cause disruption in
the distributor network, and also may not increase company profits, since the company must now fulfill
customer orders directly and provide customer service, as well as maintain the distribution channel.

Example of a Trade Discount

ABC International offers its resellers a trade discount. The retail price for a green widget is $2. One reseller
orders 500 green widgets, for which ABC grants a 30% trade discount. Thus, the total retail price of $1,000 is
reduced to $700, which is the amount that ABC bills to the reseller. The trade discount is therefore $300.

Computing Trade Discounts, Net Price & Discount Series

The list price, or catalog price of an item, is the price for which you can generally sell an item. You can purchase the item
at a trade discount, which is a discount off the list price. The trade discount rate is the amount of the discount expressed
as a percentage. The net price is the price you actually pay for the item.