Gaining earnings is the purpose of every commercial activity. At the same time, it is important not only to have revenue but also to be profitable. The lucrativeness can be expressed in financial terms, i.e. a currency value, or in percentage. However, before you take a calculator and shift to mathematical computations, it is essential to get acquainted with certain formulas and metrics.
If you have no idea why one needs to get involved in versatile calculations, have a look at the following assumption. Any small business with low cost-effectiveness won’t be able to grow. Certainly, many entrepreneurs are OK with such a state of affairs. Still, if you strive for a commercial evolution, you need to increase rates of gross profit margin calculation. Still, first things first. Therefore, let’s start with the core metric of the business earning capacity.
1. Gross profit definition
As you understand, the notion of this term means earnings. However, it is not a simple value of money that is obtained by selling a certain service or product. For example, you provide moving services. One order has brought you $100. This is not revenue but gross income. The latter can be derived from the revenue by deducting COGS. Do not be afraid of this acronym since it stands for the Cost Of Goods Sold. Otherwise speaking, you need to subtract all expenses that were incurred during the service rendering. So, sales profit is calculated as follows: Revenue – COGS.
The formula offered by Investopedia is simple, but there is no clear understanding what the said expenses may include. In fact, every detail that has to be paid for to render services is counted. These are usually referred to as variable costs such as shipping, materials, equipment, sales staff commissions, direct labor, utilities, credit card fees, etc. It is important to distinguish variable and fixed costs. The latter is not covered by gross income and is not included in the formula. Advertising, rent, insurance, office supplies, and salaries of directly-involved-in-production staff are considered as fixed charges.
Another point to mention before switching to gross profit margin for service business calculation is operating profit. It is often confused with gross income but it should be not. Operating earnings is a lower value since it is formed on the basis of sales profit by deducting operating expenses (utility costs, property taxes, repair costs, legal fees etc.). So, if your revenue is $100 and costs to earn the revenue amounts to $70, the gross profit is $30. We will need this value to calculate the principal metric of the business production efficiency.
2. Gross profit & gross profit margin difference
The major difference between these two terms lies in the measured value. The second dissimilarity is the calculation formula and their purpose. Nevertheless, both values are equally important since you won’t be able to find out gross profit margin for service business without the cost of goods sold if gross income is unknown. Still, what does change with adding the word “margin”?
GPM is a measure to analyze a financial soundness of the entrepreneurship. It is often referred to a combination of words gross and margin without profit. It can be obtained by dividing GP by revenue and multiplying by 100%. In other words, the formula looks as follows:
GPM = (revenue – COGS)/revenue*100
Based on our example above, we will obtain the following value:
GPM = (100-70)/100*100=30%.
According to the result, the company earned 30 cents for every $1 of services.
The first level of earning capacity is represented by gross income. Based on this metric, one can analyze a company’s efficiency at providing a service in comparison with competitors. Gross margin is intended for comparison business models.
3. Why you need to calculate gross profit margin
It was already mentioned that gross margin is needed for comparison. Still, what is the benefit of being compared with similar businesses? Well, if you do such a comparison, you will have an answer to the question “What is the average gross profit margin for a service business?” As soon as you make several calculations, you are able to compare your GPM with the average value and understand the current position of your business. In fact, this metric indicates the financial success and expediency of a service or product. Any entrepreneurship should strive for a higher value since it shows how much the company retains on each dollar of the service sale.
If you look at the example above, you will see that 30 cents on each US dollar come to the company’s moneybox. Though it is not the next income, the metric does matter.
Having compared the gross margin of your business with the average value, you would learn the current state of your commercial activity. And why this information is required will be described after you perform some mathematical calculations for getting GPM.
4. How to calculate gross profit margin for service business
The GPM calculation comprises three steps. The first one deals with learning the gross income. As it was mentioned above, you will need two parameters – variable charges and total earnings. Subtract the smaller value from the larger one to get gross profit. If the larger value in the formula is represented by variable costs, you can stop at this step because apparently your business has failed.
Those who obtained a positive result by a proper subtraction can move on to the second step that can be titled as “Gross Profit Margin How to Calculate”. The title is bigger than the actual mathematical calculation. All you need to do is to divide your obtained gross income by total earnings. Voila!
The final step is bringing your gross margin to the percentage. It is done by placing the dot in your decimal value by two characters to the right and removing the null in the front. I.e., for 0.27, you will get 27. And do not forget to add the percent symbol.
5. Indicators meaning and how to use this information
An adequate GPM ensures payment for operating costs. Besides, it is the metric to analyze the financial status. If the gross profit margin is unstable, it evidences troubles in the enterprise model. In addition, fluctuation from the average GPM in the industry or market is also a sign of positive (if higher) or negative (if lower) state of affairs.
Regulatory changes in the industry, as well as alteration of a pricing strategy within the business, may cause changes in the metric as well. For example, selling services above par in the market with equality of other items results in a higher GPM. The puzzle is that clients may refuse to purchase the service in case of too exaggerated prices.>
The calculation technique was shortly introduced in one of the paragraphs above. However, it might be not enough to get at the essence of the issue. Hence, you are provided with a detailed guide based on a decent example.
At first, some background information is needed. It was decided to show it in the form of a chart.
|Motor vehicles distribution cost||13,541|
|Distribution, administrative, and other expenses||2,356|
|Legal services interest, operating costs, and other charges||2,695|
Initially, we need to find out the gross profit. To get this metric, such elements as total revenues and the above-described COGS are needed. The latter amounts to 13,541 since other items are not included in variable costs. Subtraction of COGS from revenues shows gross income. In the context of our example, it amounts to 6,570.
The next step deals with a division. The sales profit result should be divided by total revenues. Our value is 0.326.
And the final step is to bring the gross margin value into the percentage by multiplying the fraction by 100. As a result, we have 32.6%. Based on this, you can find out your market position compared to competitors.
Comprehending gross margin is a vital component of sound financial management (for more, check out these tips from Accounting Department). Having either a product or service-oriented business, the metric is a great tool for analyzing performance and ROI.