Financial Explainer — gross profit margins and cost of sales

This blog is part of a series designed to help small business owners understand their financial statements. We take each component and explain it in simple terms.

In this segment, we're going to explain gross profit margins. In theory, that seems straightforward but to really get to grips with it, you need to understand what makes up your cost of sales.

Essentially, your gross profit is what's left from your sales after deducting all the direct costs you incur to produce your product or service and deliver it to your customers.

You then just need to express that as a percentage of your sales.

Here’s how to calculate your gross profit margin: 100 x (sales - direct cost of sales) / sales

Where people get stuck is in understanding what specifically they should include in their direct cost of sales (or COGS — cost of goods sold). Here's a quick run-down:

For product companies:

Direct material costs: The costs for the raw materials and other components that are used directly in manufacturing your product. For example, the steel and other materials used to make a vehicle in a car manufacturing plant.

Direct labour costs: The wages or salaries directly associated with producing the product. For example, assembly line workers' wages.

Manufacturing overhead: These are the indirect costs related to your production. For example, your factory rent and utilities.

For service companies:

Direct labour costs: The wages or salaries of employees directly involved in delivering your service. For example, the salary of a software developer working on a client project.

Direct expenses: Costs that are directly attributable to providing your services. For example, payments made to a subcontractor assisting with a consulting project.

Service-specific costs: Expenses that are specific to delivering your services. For example, software licensing fees used in providing accounting services.

Your cost of sales should not include:

Marketing expenses

Administrative expenses

Overhead expenses that are not tied directly to producing goods, e.g. office rent and utilities.

Travel expenses

Salesforce and admin salaries

In summary, your cost of sales encompasses expenses directly tied to producing goods or delivering services. It excludes any broader operational and administrative costs necessary to run the business as a whole.

When all is said and done, what does your gross margin tell you about your business?

A high gross margin is a sign that your business is generating a lot of value. If you can sell a product or service for 2x what it costs you to produce (i.e. a gross margin of 50%) it means that what you do for your customers is something they value highly and will pay for handsomely.

Of course, gross margin isn’t the end of the story. You also need to be able to persuade your customer to buy your product or service and cover all the other running costs of your business and still make a profit.