Gross Profit Margin: How to Calculate and What It Tells You

Gross profit margin (GPM) is a key financial metric that measures your company's profitability. It represents the percentage of net revenue you make that exceeds the cost of goods sold (COGS). GPM provides valuable insights into your company's operational efficiency and pricing strategies.

Despite its importance, I've seen too many business owners focus solely on revenue while ignoring gross profit margin. You could be selling like crazy and still face financial struggles if your margins are off. This metric is crucial to understanding your company's true financial health and making informed decisions that drive sustainable growth.

Learn how to calculate gross margin percentage, why it matters for assessing financial performance, and how you can boost profitability and implement more effective selling strategies using real sales data.

GPM is a key financial metric that indicates your company's profitability and operational efficiency. It measures the percentage of revenue remaining after covering the cost of goods sold (COGS). Simply put, GPM shows how much profit your company makes for each dollar of revenue after paying for direct production costs.

The formula for calculating GPM is: GPM = (Revenue – COGS) / Revenue x 100

Expressed as a percentage, the gross margin percentage offers a clear picture of your company's ability to generate profit from its sales. A higher GPM indicates your company is effectively managing its production costs and pricing strategies, allowing it to retain a larger portion of its revenue as profit. A lower GPM suggests your company may be struggling to control costs or set competitive prices.

GPM ultimately helps you assess financial performance and make informed decisions. It allows you to compare your profitability with industry benchmarks, identify areas for cost savings, and evaluate the effectiveness of your pricing strategies. Artificial intelligence (AI) can help you analyze GPM and provide actionable insights.

Gross profit margin and net profit margin measure different things, and mixing them up can harm your understanding of your business's financial performance.

Gross profit margin only accounts for the direct costs of creating your goods or services. For manufacturers, this would typically include expenses like raw materials, rent for the factory, and production-related labor. For businesses selling intangible products (say, software-as-a-service), direct costs usually cover infrastructure (like servers) and resources directly tied to ‌product creation (like engineers).

Net profit margin accounts for all your operational expenses, including marketing, sales teams, office rent, and administrative costs. It shows your overall profitability after all business expenses.

Here's why this distinction matters. You might have great gross margins but poor net margins because your operating costs are too high. A high gross margin doesn't automatically mean a healthy business if your operational expenses are through the roof.

Gross profit margin is everyone's business. There's a misconception that only big companies should focus on it, but that's not true. The smaller the company, the more vital it is because resources are limited.

A gross profit margin provides real cost control. Many companies use cost-plus pricing in their quoting systems. You might say, "Here's the bottom price; sell on top of this." This method helps ensure you understand and control your costs. You may not know your true cost of goods, so it's essential to have list prices and guidelines for volume discounts.

It also helps you understand the value-creation process. You can understand the ratio between the cost of the goods or services you're selling and the market price or perceived price. This helps you understand the value you're creating and how to market that value to your customers.

Lastly, measuring gross profit margin reveals operational efficiency. Unlike just looking at revenue, gross profit margin includes the cost of goods sold, giving you a clearer picture of whether you're running an efficient operation.

The key is understanding what goes into the cost of goods sold versus what doesn't. The formula for gross profit margin calculation is:

Gross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue × 100

Here's how I break it down:

1. Start with total revenue or all income from sales
2. Calculate your true COGS, only direct production costs
3. Subtract COGS from revenue, which gives you gross profit
4. Divide gross profit by revenue and multiply by 100

Let me give you an example. Say you have $500,000 in revenue. Your COGS includes $200,000 in materials, $80,000 in direct labor, and $20,000 in production overhead, totaling $300,000. Your gross profit is $200,000, so your margin is 40%.

People want better margins, so they include marketing costs in their calculations. The gross margin only considers the cost of producing the goods. Reducing your sales team won't increase your gross profit margin; it will just change how you go to market.

A good profit margin isn't defined by a specific number, but by your company's ability to maintain sustainable profitability within your competitive landscape. While higher margins generally indicate efficient operations, what qualifies as "good" varies greatly across sectors.

Several factors contribute to achieving good profit margins, including efficient production processes that minimize waste, strong pricing power that allows premium pricing, and a strategic focus on high-margin products or services. Companies with good margins typically excel at cost management while maintaining quality, have established competitive advantages that support their pricing, and continuously optimize their operations. Rather than chasing the highest possible margin, successful businesses focus on sustainable margins that support reinvestment and growth.

The most important aspect of a good profit margin is its consistency and trajectory over time. A margin that allows your business to cover all expenses, invest in future growth, withstand economic downturns, and provide returns to stakeholders is fundamentally solid, whether it's 5% or 50%. Focus on improving your margin through operational efficiencies and strategic positioning rather than comparing absolute numbers to unrelated industries.

Here are ways you can increase gross profit margin and improve overall financial performance.

I see customers move from cost plus pricing to set pricing. Instead of saying, "Here's my cost, let me add a markup," they say, "Here's my set price, and here are the discount guidelines." Senior salespeople who have sold the product for a long time usually understand the cost of goods well, but structured pricing helps protect their margins. The right sales planning software can set the appropriate price based on your company's financials, without having to guess on every deal.

Use ROI documents to demonstrate the business value you're providing. You're not just thinking, "Here's what it costs, I want to make X on top of it." Instead, it's "Here's the value we're bringing, which is why we're not going to discount by 20%, but we'll discount an amount that makes sense given the value."

One product strategy is aiming to sell more of your highest-margin products and gradually phasing out less profitable ones. Analyze your portfolio and shift focus to higher-margin offerings.

Aim to upsell and cross-sell your products and services. When you're already engaging with a customer who trusts you enough to make a purchase, that's the perfect opportunity to introduce complementary products or premium versions that often have higher margins. Instead of just selling the basic version, show the customer how a premium option better meets their needs or how an extra service protects their investment.

Change how you approach discounts. Once you recognize the value you offer, there's less reason to give discounts just for the sake of it. Establish approval processes to ensure you can't go below certain price levels without proper justification. The right software can create guardrails to prevent unnecessary discounting.

Gross profit margins differ greatly across industries, reflecting the distinct cost structures and business models of each sector. According to a study conducted by NYU, software companies show some of the highest gross profit margins, with system and application software averaging 72.38% and entertainment software reaching 65.38%. Other high-margin sectors include retail real estate investment trusts (REITs) at 77.48% and financial services (non-bank and insurance) at 68.37%. These industries typically have lower direct costs relative to their revenue, allowing them to keep more of each dollar earned.

Manufacturing and traditional retail sectors show much more variation and generally lower margins. The machinery sector averages 37.08%, while general retail sits at 32.22%. Healthcare displays notable differences within the same broad industry, with healthcare products achieving margins of 56.04% while healthcare support services only reach 13.16%.

Lower-margin industries include auto and truck manufacturing at 11.11%, food wholesalers at 15.36%, and oilfield services at 10.71%, reflecting the commodity-like nature of their products or high manufacturing costs.

To illustrate how these industry averages translate to individual businesses, consider these hypothetical examples:

• A software company might report a gross profit margin of 37.6%, meaning it would keep $0.376 for every dollar of revenue after accounting for direct production costs.
• A digital retail business can reach 41.9% margins, keeping $0.419 per revenue dollar after fulfilling orders, while a wholesale operation might operate at 24.9% margins, retaining $0.249 per dollar after purchasing and transporting merchandise.

These numbers, however, shouldn't be judged in isolation. A high margin isn't automatically positive if a company is underinvesting in service quality, product development, or market expansion. Similarly, a lower margin isn't necessarily problematic if it's appropriate for the industry, and the company effectively manages costs while maintaining competitive positioning. The key is understanding how your margins compare to industry benchmarks and whether they support sustainable business growth and profitability.

The right software systems can make a huge difference in managing cost control, setting up sales guardrails, and ensuring your team has the visibility they need to protect margins.

Sales Cloud's Configure Price Quote (CPQ) solution helps protect your gross profit margins with customizable pricing controls and automated guardrails. It lets you set floor prices, implement approval workflows for major discounts, and send automated alerts when quotes approach margin limits. This provides your sales team with the flexibility they need while preventing margin loss from arbitrary discounts, giving managers insight into potentially risky deals before they close.