The short answer
Gross profit is the selling price minus the direct cost of what you sold. Gross margin is that profit as a percentage of the selling price. If you sell something for £100 that cost you £40, your gross profit is £60 and your gross margin is 60%.
Three rules cover most of what goes wrong:
- Margin is a share of the price; markup is a share of the cost. The same £60 profit is a 60% margin but a 150% markup.
- Leave VAT out. If you are VAT-registered, work out margin on the price before VAT, because the VAT belongs to HMRC.
- Gross margin is not take-home. Rent, wages, software and tax all come out of gross profit before you see any of it.
How to work out gross margin
You need two figures for one sale, or for a whole period: the selling price and the direct cost.
- Gross profit = selling price − direct cost
- Gross margin = gross profit ÷ selling price × 100
- Markup = gross profit ÷ direct cost × 100
- Selling priceBefore VAT£100.00
- Direct costStock, materials, packaging−£40.00
- Gross profit£60.00
- Gross margin£60 ÷ £10060%
Direct cost means the costs that rise and fall with each sale. For a shop that is the wholesale price of the stock plus anything spent getting it ready to sell. For a café it is the ingredients and the cup. For a service business it might be subcontractor fees or materials used on the job. Accountants call this cost of sales or cost of goods sold.
Overheads are left out on purpose. Your rent is the same whether you sell ten things this week or a hundred, so it does not belong in the cost of any one sale. Keeping them separate is what lets gross margin tell you whether each sale is worth making.
Margin and markup
Margin and markup describe the same profit from two angles. Margin compares it with the price; markup compares it with the cost. Because the price is always bigger than the cost when you make a profit, the margin is always the smaller of the two numbers.
| Markup on cost | Gross margin | Price of a £60 item |
|---|---|---|
| 25% | 20.0% | £75.00 |
| 33.3% | 25.0% | £80.00 |
| 50% | 33.3% | £90.00 |
| 66.7% | 40.0% | £100.00 |
| 100% | 50.0% | £120.00 |
| 150% | 60.0% | £150.00 |
| 200% | 66.7% | £180.00 |
| 300% | 75.0% | £240.00 |
To convert between them:
- Margin from markup: markup ÷ (1 + markup). A 100% markup is 1 ÷ 2 = 50% margin.
- Markup from margin: margin ÷ (1 − margin). A 40% margin is 0.4 ÷ 0.6 = 66.7% markup.
The costly mix-up
If you want a 40% margin but add 40% to the cost, you charge £84 for a £60 item instead of £100. Your real margin is 28.6%, and you give away £16 on every sale. When someone quotes a percentage, always ask whether they mean margin or markup.
Retailers and wholesalers often talk in markup because it is easy to apply to a cost price. Accountants, lenders and investors almost always talk in margin, because it can be compared across businesses of any size. Our retail markup calculator works the other way round, from a target to a price.
Margin and VAT
If you are VAT-registered, the VAT you add to a price is not yours. You collect it for HMRC and pay it over with your VAT return. Work out margin on the price before VAT, and use costs before VAT too, because you reclaim the VAT on them.
- Shelf price£30.00
- VAT inside it£30 ÷ 6£5.00
- Price before VAT£30 ÷ 1.2£25.00
- Gross profit£25 − £10£15.00
Using the shelf price would give a margin of 66.7%, which overstates it by more than six percentage points. That kind of error is easy to make when you price from a till receipt or a marketplace listing.
If you are not VAT-registered, there is no VAT to strip out of your price, but the VAT you pay suppliers is a real cost you cannot reclaim. Include it in your cost figure. The VAT calculator takes VAT on or off any amount.
On the Flat Rate Scheme the picture is different again: you charge 20% VAT but pay HMRC a lower flat percentage, so part of the VAT stays with you as extra income. That gain is taxable, and it is usually small. The flat rate VAT calculator shows how much.
Gross, operating and net margin
Gross margin is the first of several margins in a set of accounts. Each takes off another layer of cost:
- Gross margin: after direct costs only.
- Operating margin: after overheads too, such as rent, wages, software, insurance and marketing.
- Net margin: after interest and tax as well.
- Sales before VAT£120,000
- Direct costs1,200 × £40−£48,000
- Gross profit60% gross margin£72,000
- Overheads−£45,000
A healthy gross margin can still leave a thin profit if overheads are high. In this example the business needs 750 sales a year just to cover its overheads (£45,000 ÷ £60). Everything above that is profit before tax. The break-even calculator works this out from your own numbers.
What margin do you need?
There is no single good margin. A business with low overheads and high volume, like a wholesaler, can do well on a thin gross margin. A business with expensive premises, skilled staff or few sales, like a boutique or a design studio, needs a much higher one. The useful question is not “what is normal?” but “what do my numbers need?”
Work it backwards from your overheads and the profit you want:
- Add your yearly overheads to the profit you want before tax.
- Divide by the sales you realistically expect, before VAT.
- The answer is the gross margin you need.
- Overheads a year£45,000
- Profit wanted before tax£30,000
- Expected sales before VAT£150,000
If your current margin is below that, you have three levers: raise prices, cut direct costs, or sell more. The next sections show how sensitive profit is to each.
What a discount really costs
A discount comes straight off your gross profit, not off your sales. A 10% discount on a product with a 40% margin does not cost you 10% of the profit; it costs a quarter of it. To make the same gross profit you then need a third more sales.
| Discount | 25% margin | 40% margin | 60% margin |
|---|---|---|---|
| 5% off | +25% sales | +14% sales | +9% sales |
| 10% off | +67% sales | +33% sales | +20% sales |
| 15% off | +150% sales | +60% sales | +33% sales |
| 20% off | +400% sales | +100% sales | +50% sales |
| 25% off | No profit left | +167% sales | +71% sales |
The lower your margin, the more dangerous discounting becomes. At a 25% margin, a 25% discount means you sell at cost: every extra sale adds work and nothing else. Before running a sale, check the extra volume it needs against what you think it will bring in.
Better than a straight discount
Bundles, free delivery over a threshold, or “buy two, get the third half price” often protect margin better than a flat percentage off, because they raise the amount each customer spends.
Raising prices
The same maths works in your favour when you raise prices. Every pound of a price rise is extra gross profit, so you can lose some sales and still come out ahead.
| Price rise | At a 40% margin | At a 60% margin |
|---|---|---|
| 5% | 11.1% | 7.7% |
| 10% | 20.0% | 14.3% |
A business on a 40% margin that puts prices up 10% can lose one sale in five and still make the same gross profit, with less stock to buy and less work to do. In practice many customers do not leave over a modest rise, especially if the price was set some time ago and costs have gone up since.
When your costs go up
When a supplier puts its price up, your margin falls unless you pass the rise on. There are two ways to respond, and they lead to different prices.
- Cost
- £40 → £44
- New price
- £104
- Profit each
- £60
- Margin
- 57.7%
- Cost
- £40 → £44
- New price
- £110
- Profit each
- £66
- Margin
- 60%
If you absorb the rise and keep your £100 price, your margin falls from 60% to 56%. Keeping the margin at 60% needs a price of £110, a 10% rise to match the 10% cost increase. Keeping the same profit per sale needs only £104. Which is right depends on your overheads: if they are rising too, keeping the percentage margin is usually safer.
Ways to improve your margin
- Review prices at least once a year. Costs creep up; prices often do not.
- Know your margin by product or service. An average can hide items that lose money. Drop them or reprice them.
- Negotiate with suppliers. Ask for volume discounts, longer payment terms or cheaper delivery. Even a small cost saving drops straight to gross profit.
- Cut waste. Spoiled stock, returns and rework are direct costs. In food businesses, portion control alone can move the margin several points.
- Sell more of your best-margin lines. Put them where customers see them first.
- Watch platform and card fees. Marketplace commission and payment fees are a cost of each sale. Treat them as direct costs when you work out margin.
- Charge for extras. Delivery, rush jobs and changes to a brief all take time or money. Pricing them separately stops them eating into the main sale.
Margin in your accounts and tax return
On a sole trader’s Self Assessment return, your sales go in as turnover, and the cost of the goods you bought to resell goes in as an allowable expense. Gross margin is not a box on the form, but the figures behind it are.
Most sole traders now use the cash basis, which counts money when it comes in or goes out. Under the cash basis, stock you buy this year but sell next year still counts as a cost this year, so your gross margin can look low in a year when you build up stock and high when you sell it down. Traditional accounting matches each cost to the sale it relates to, which gives a steadier margin.
Limited companies show gross profit near the top of their profit and loss account. Corporation Tax is charged on the profit after overheads, not on gross profit. See the Corporation Tax calculator and the sole trader tax calculator for the tax on your final profit.
For other percentage sums, such as a percentage change between two prices, use the percentage calculator.