Gross profit margin: formula, example and why it matters

Gross profit margin is the percentage of your sales left after you deduct the direct cost of producing what you sold. Gross profit is the amount in pounds, and the margin is that amount expressed as a share of sales.

The British Business Bank’s glossary defines margin as the amount of money a company makes, expressed as a percentage. Gross profit margin applies that idea to the earliest stage of the profit and loss account, before the running costs of the business are counted.

Gross profit margin = (sales − direct costs) ÷ sales × 100. First work out gross profit by taking the direct costs off your sales, then divide that by your sales and multiply by 100.

A direct cost is one that exists only because you made or delivered the thing you sold, such as materials, stock bought for resale or a subcontractor paid for a specific job. Costs of running the business whether or not you make a sale are overheads and sit further down.

• Usually direct: raw materials, goods bought to resell, packaging, subcontractors on a job, and in some businesses the wages of staff who make the product or deliver the service.
• Usually overheads: rent, office costs, software, marketing, insurance and accountancy fees.

Where a cost falls can change the margin, so decide the rule once and apply it every period. If you are unsure where wages belong, ask your accountant, because the answer depends on the type of business.

Margin is profit as a share of the selling price, while markup is profit as a share of the cost. The same sale gives two different percentages, which is a common source of mistakes when pricing.

A 40% margin is therefore not the same as adding 40% to your costs. If you price by adding a percentage to cost, work out the margin that results before you rely on it.

Gross profit margin stops after direct costs, while net profit margin is measured after every cost, interest and tax. Net margin is therefore lower, and it is the better guide to what the whole business keeps.

Gross margin answers whether each sale is worth making. Net margin answers whether the business as a whole is. A business can have a strong gross margin and still lose money if its overheads are too heavy. Our guide to net profit shows the steps between the two, and our guide to the profit and loss account shows where both appear.

Gross profit margin matters because it is the pool from which every other cost is paid, including wages, rent, loan repayments and tax. If it is too thin, no amount of cost-cutting elsewhere may be enough.

• Pricing: it shows whether your prices cover what the work really costs.
• Trends: a margin that slips from one period to the next can be the first sign of supplier price rises or discounting.
• Mix: it shows which products or jobs earn more, so you can steer towards them.
• Funding: the money available to repay finance comes out of what is left after direct costs and overheads, so a stronger margin gives more room.

There is no single good figure, because sensible margins differ widely between sectors and business models. A business selling goods it buys in tends to look different from one selling its own skilled time.

A more useful test than a headline benchmark is whether your margin is steady or improving against your own earlier periods, and whether it leaves enough to cover your overheads and any repayments. We do not quote sector averages here because they vary by source and year. Your accountant or trade body is a better place to look for like-for-like comparisons.

You improve gross profit margin by raising what you earn per sale, cutting direct costs or changing what you sell. Each lever has a trade-off, so change one at a time and watch the result.

If a thin margin is leaving the business short of cash, the answer is usually a pricing or cost fix rather than borrowing. Finance can cover a timing gap, but it does not repair a margin that does not pay for the work. Our guide to working capital explains the difference between a timing gap and a structural one.

Capzy is a credit broker, not a lender, and is paid by the lender. We introduce businesses to lenders that match the finance they need, and the lender assesses your accounts, including your margins.

If you want to see what might be available, you can check your funding options with a soft search that does not affect your credit score. A full application to a lender may involve a hard search, and any offer is subject to status and lender criteria. You can also browse our directory of business lenders. Capzy does not give accounting advice, so ask your accountant to check the figures.