Gross profit margin

Gross profit margin is the share of your sales that is left once you have paid for the goods you sold. A 60% gross margin means that out of every $10 a customer pays, $6 remains to cover rent, wages, utilities and everything else — and whatever is left after those is your profit. It is the single most useful number for judging whether your prices are right.

The gross profit margin formula

The same formula works for one item or for a whole month. For a single item, revenue is the selling price and COGS is what one unit cost you. For a period, revenue is total net sales and COGS is the cost of everything that sold — see cost of goods sold for how to work that out.

A worked example

A gift shop sells a candle for $25 that costs $10 from the supplier. Gross profit on one candle is $25 − $10 = $15, and gross margin is $15 ÷ $25 = 60%.

Across a whole month the shop takes $40,000 in net sales, and the goods it sold cost $17,000. Gross profit is $23,000 and gross margin is $23,000 ÷ $40,000 = 57.5%. The overall figure is lower than the candle’s because the shop also sells lower-margin items such as greeting cards and chocolate. The calculation is identical in any currency.

Margin is not markup

The most common pricing error is treating margin and markup as the same number. Margin divides profit by the selling price; markup divides profit by the cost. The candle above has a 60% margin but a 150% markup ($15 ÷ $10). To convert, use margin = markup ÷ (1 + markup) and markup = margin ÷ (1 − margin).

Why gross margin matters for a small business

Gross margin decides how much each sale contributes to your fixed costs. If a café’s rent, wages and bills come to $9,000 a month and its gross margin is 65%, it needs about $13,850 in sales just to break even ($9,000 ÷ 0.65). Drop the margin to 55% and the break-even point rises to about $16,360 — the same café now needs roughly $2,500 more in sales a month to stand still.

Margin per item also tells you where to put your effort. The item that sells most is not always the one that earns most; a salon’s retail shelf, a café’s pastries or a shop’s accessories can carry very different margins from the core product. Knowing each item’s margin lets you promote the ones that pay, reprice the ones that do not, and notice quickly when a supplier price rise has eaten into a best seller.

Common mistakes

• Confusing margin with markup. Adding 50% to cost gives a 33.3% margin, not 50%.
• Including sales tax in revenue. Tax collected is not yours; including it inflates both revenue and margin.
• Forgetting discounts and refunds. A 20% discount on a 60%-margin item cuts its margin to 50%, not 40% — and the cash gross profit falls by a third.
• Averaging item margins. The overall margin is weighted by how much of each item you sell; the simple average of item margins can be far from the real figure.
• Comparing gross margin with net margin. Gross margin ignores overheads. A healthy gross margin can still sit alongside a loss if rent and wages are too high.

How it relates to other terms

Gross margin is built from cost of goods sold, and is the mirror image of markup. It pairs naturally with average order value: gross margin × average order value tells you the gross profit a typical order brings in, which is the number to raise when you cannot easily raise the number of customers.