Contents Table
Key Takeaway
- Gross profit percentage is the ratio of gross profit to net sales revenue, expressed as a percentage.
- It measures how much of each sales rand is left after deducting the cost of goods sold.
- It is important for small and medium-sized businesses to monitor and improve their gross profit percentage, as it reflects their pricing, sales volume, product mix, and cost efficiency.
- To calculate gross profit percentage, use the following formula: Gross Profit Percentage = (Net Sales Revenue – Cost of Goods Sold) / Net Sales Revenue * 100%
- To increase gross profit percentage, you can try to increase your sales price or volume, diversify your product offerings, or reduce your cost of goods sold.
- Thrive CFO is a cloud accounting firm that can help you optimise your gross profit percentage and other financial metrics, by providing you with real-time data, expert guidance, and customised solutions.
Introduction
Gross profit percentage is one of the most important financial metrics for any business, especially for small and medium-sized businesses (SMBs) that operate in competitive and dynamic markets. It tells you how much of each sales rand is left after deducting the cost of goods sold, which are the direct expenses incurred in producing and selling your goods or services. The higher your gross profit percentage, the more profitable your business is.
In this article, we will explain what gross profit percentage is, how to calculate it, how to interpret it, and how to improve it. We will also introduce you to Thrive CFO, a cloud accounting firm that provides virtual CFO services to consultancies, professional services, and creative agencies in South Africa. Thrive CFO can help you with your monthly accounting, financial reporting, tax compliance, and business advisory needs, including optimising your gross profit percentage and other financial metrics.
By the end of this article, you will be able to:
- Understand what gross profit percentage is and why it is important for your business performance and profitability.
- Calculate your gross profit percentage using a simple formula and an example.
- Compare your gross profit percentage with industry benchmarks and competitors to assess your competitive advantage or disadvantage.
- Analyse the factors that affect your gross profit percentage, such as pricing, sales volume, product mix, and cost efficiency.
- Implement some practical tips and strategies to increase your gross profit percentage and grow your business.
- Contact Thrive CFO for more assistance and advice on your financial matters.
What is Gross Profit Percentage?
Gross profit percentage is the ratio of gross profit to net sales revenue, expressed as a percentage. It measures how much of each sales rand is left after deducting the cost of goods sold, which are the direct expenses incurred in producing and selling your goods or services.
The formula for calculating gross profit percentage is:
Gross Profit Percentage = (Net Sales Revenue – Cost of Goods Sold) / Net Sales Revenue * 100%
Net sales revenue is the total amount of money your business earns from selling your goods or services, minus any discounts, returns, or allowances. Cost of goods sold is the total amount of money your business spends on producing and selling your goods or services, such as raw materials, labor, and inventory costs.
For example, suppose your business sells handmade candles. In a month, you sell 1,000 candles for R50 each, generating a net sales revenue of R50,000. To make and sell these candles, you spend R10,000 on wax, wicks, fragrance oils, and packaging, and R5,000 on labor and overhead costs. Your cost of goods sold is R15,000. To calculate your gross profit percentage, you would use the following formula:
Gross Profit Percentage = (R50,000 – R15,000) / R50,000 * 100% = 70%
This means that for every R1 of sales revenue, you earn R0.70 of gross profit, and R0.30 goes to cover your cost of goods sold. Your gross profit percentage is 70%, which is quite high.
What is Cost of Goods Sold?
Cost of goods sold (COGS) is the total amount of money your business spends on producing and selling your goods or services. It includes the direct expenses that are directly attributable to the production and sale of your goods or services, such as:
- Raw materials: The materials that are used to make your goods or services, such as wax, wicks, and fragrance oils for candles, or flour, eggs, and sugar for cakes.
- Labor: The wages and salaries that are paid to the workers who are involved in making your goods or services, such as candle makers, bakers, or carpenters.
- Inventory: The cost of storing and maintaining the goods that are ready for sale or in the process of being made, such as rent, utilities, insurance, and depreciation.
- Overhead: The indirect expenses that are related to the production and sale of your goods or services, but are not directly traceable to them, such as electricity, water, gas, and transportation.
The formula for calculating cost of goods sold is:
Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory
Beginning inventory is the value of the goods that you have in stock at the start of the accounting period, such as the beginning of the month or the year. Purchases are the value of the goods that you buy or produce during the accounting period, such as the wax, wicks, and fragrance oils that you buy to make candles. Ending inventory is the value of the goods that you have in stock at the end of the accounting period, such as the candles that you have not sold yet.
For example, suppose your business sells handmade candles. At the beginning of the month, you have 200 candles in stock, valued at R10 each, giving you a beginning inventory of R2,000. During the month, you buy 800 candles from a supplier for R8 each, and you make 200 candles yourself, spending R2,000 on wax, wicks, and fragrance oils. Your purchases are R8,000 (800 x R8) + R2,000 = R10,000. At the end of the month, you have 100 candles left in stock, valued at R10 each, giving you an ending inventory of R1,000. To calculate your cost of goods sold, you would use the following formula:
Cost of Goods Sold = R2,000 + R10,000 – R1,000 = R11,000
This means that you spent R11,000 on producing and selling 1,100 candles during the month. Your cost of goods sold per candle is R11,000 / 1,100 = R10.
How to Interpret Your Gross Profit Percentage
Your gross profit percentage can tell you a lot about your business performance and profitability. It can help you answer questions such as:
- How profitable is your business compared to your industry or your competitors?
- How efficient is your business in managing your cost of goods sold?
- How much room do you have to cover your operating expenses and generate net profit?
- How sensitive is your business to changes in your sales price, sales volume, product mix, or cost of goods sold?
To interpret your gross profit percentage, you need to compare it with some benchmarks or standards, such as:
- Industry averages: You can find the average gross profit percentage for your industry or sector from various sources, such as financial reports, databases, websites, or publications. For example, according to [this website], the average gross profit percentage for the candle industry in South Africa was 58.7% in 2022.
- Competitors: You can also compare your gross profit percentage with your direct or indirect competitors, who offer similar or substitute products or services to your target market. You can obtain their gross profit percentage from their financial statements, websites, or other sources, if they are publicly available. For example, according to [this website], one of your competitors, Candle Co., had a gross profit percentage of 65% in 2022.
- Historical trends: You can also track your gross profit percentage over time, such as monthly, quarterly, or yearly, to see how it changes and what causes the changes. You can use your own financial records, such as income statements, to calculate your gross profit percentage for each period. For example, according to your income statements, your gross profit percentage was 60% in January, 65% in February, and 70% in March.
By comparing your gross profit percentage with these benchmarks, you can assess your competitive advantage or disadvantage, and identify your strengths and weaknesses. For example, if your gross profit percentage is higher than the industry average or your competitors, it means that you have a strong pricing power, a loyal customer base, a unique product mix, or a low cost of goods sold. On the other hand, if your gross profit percentage is lower than the industry average or your competitors, it means that you have a weak pricing power, a high customer churn, a low product differentiation, or a high cost of goods sold.
Analyse the factors that affect your gross profit percentage, such as:
- Pricing: Your sales price determines how much revenue you generate from each sale. If you increase your sales price, you can increase your gross profit percentage, as long as your sales volume does not decrease significantly. However, if you decrease your sales price, you can decrease your gross profit percentage, unless your sales volume increases significantly.
- Sales volume: Your sales volume determines how many units of your goods or services you sell in a given period. If you increase your sales volume, you can increase your gross profit percentage, as long as your cost of goods sold does not increase proportionally. However, if you decrease your sales volume, you can decrease your gross profit percentage, unless your cost of goods sold decreases proportionally.
- Product mix: Your product mix determines the proportion of each product or service that you sell in relation to your total sales. If you sell more of the products or services that have a higher gross profit percentage, you can increase your overall gross profit percentage. However, if you sell more of the products or services that have a lower gross profit percentage, you can decrease your overall gross profit percentage.
- Cost efficiency: Your cost efficiency determines how well you manage your cost of goods sold. If you reduce your cost of goods sold, you can increase your gross profit percentage, as long as your sales revenue does not decrease significantly. However, if you increase your cost of goods sold, you can decrease your gross profit percentage, unless your sales revenue increases significantly.
By analysing these factors, you can identify the opportunities and threats for your business, and plan your actions accordingly. For example, you can decide whether to raise or lower your prices, increase or decrease your sales volume, diversify or simplify your product offerings, or improve or outsource your production processes.
How to Increase Your Gross Profit Percentage
Now that you know how to calculate and interpret your gross profit percentage, you may wonder how to improve it. There are many ways to increase your gross profit percentage, depending on your business goals, market conditions, and customer preferences.
3 Practical Tips and Strategies That You Can Try
- Increase your sales price or reduce discounts and allowances: One of the simplest and most effective ways to increase your gross profit percentage is to charge more for your goods or services, or to offer less discounts or allowances to your customers. This will increase your sales revenue and your gross profit, as long as your sales volume does not drop significantly. However, you need to be careful not to price yourself out of the market, or to lose your loyal customers to your competitors. You need to conduct a market research and a customer analysis to determine the optimal price point and the price elasticity of your goods or services. You also need to communicate the value proposition and the benefits of your goods or services to your customers, and to justify your price increase or discount reduction with valid reasons, such as quality improvement, cost inflation, or market demand.
- Increase your sales volume or diversify your product offerings: Another way to increase your gross profit percentage is to sell more units of your goods or services, or to offer more variety or options to your customers. This will increase your sales revenue and your gross profit, as long as your cost of goods sold does not rise proportionally. However, you need to be careful not to overstock your inventory, or to dilute your brand identity or focus. You need to conduct a market segmentation and a product analysis to determine the target market and the product mix for your goods or services. You also need to promote your goods or services to your existing and potential customers, and to create a loyal customer base and a referral network, through effective marketing, advertising, and customer service strategies.
- Reduce your cost of goods sold by negotiating better deals with suppliers, optimising your inventory management, or outsourcing non-core activities: Another way to increase your gross profit percentage is to lower your cost of goods sold, or the direct expenses incurred in producing and selling your goods or services. This will increase your gross profit, as long as your sales revenue does not fall significantly. However, you need to be careful not to compromise the quality or the delivery of your goods or services, or to lose your competitive edge or differentiation. You need to conduct a supplier evaluation and a cost analysis to determine the best sources and prices for your raw materials, labor, and overhead. You also need to optimise your inventory management, by using techniques such as just-in-time, economic order quantity, or ABC analysis, to reduce your inventory costs, such as rent, utilities, insurance, and depreciation. You also need to outsource your non-core activities, such as accounting, legal, or IT services, to external providers, who can offer you better quality, efficiency, or cost savings.
These tips and strategies can help you boost your gross profit percentage and grow your business. However, you should also consider other financial metrics that matter for your business success and growth, such as:
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- Operating expenses, such as rent, salaries, marketing, and taxes, which are subtracted from your gross profit to get your net profit
- Cash flow, which is the amount of money that comes in and goes out of your business, and influences your liquidity, solvency, and profitability
- Return on investment, which is the ratio of your net profit to your total assets, and shows how well you use your resources to generate profit
- Growth rate, which is the percentage change in your sales revenue, net profit, or market share, over a given period, and reflects how fast your business is growing or shrinking
Conclusion
In conclusion, gross profit percentage is one of the most important financial metrics for any business, especially for small and medium-sized businesses that operate in competitive and dynamic markets. It tells you how much of each sales rand is left after deducting the cost of goods sold, which are the direct expenses incurred in producing and selling your goods or services. The higher your gross profit percentage, the more profitable your business is.
Calculating and improving your gross profit percentage is not a simple or straightforward task. It requires a lot of data, analysis, planning, and action. It also requires a lot of time, effort, and expertise. That is why you may need some professional help and support from a trusted and experienced partner, who can handle your financial matters and advise you on your business decisions. That is where Thrive CFO comes in.
Thrive CFO is a cloud accounting firm that provides virtual CFO services to consultancies, professional services, and creative agencies in South Africa. Thrive CFO can help you with your monthly accounting, financial reporting, tax compliance, and business advisory needs, including optimising your gross profit percentage and other financial metrics. Thrive CFO can help you access real-time financial data and insights, get expert guidance and support, and enjoy customised and affordable solutions.
If you are interested in working with Thrive CFO, you can book a discovery call.
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