Gross profit margin is the amount of total sales that constitute sales profit, and can be used to defray operating cost and generate revenue for the company. The total sales price must be adjusted for returns and allowances. Returns occur when a customer receives a full refund for a returned item. Allowances are similar, except they are partial refunds used to discount a product to console a dissatisfied customer. Sales should not be cancelled during such transactions. Instead, the original sale is recorded as usual, and the refund or allowance is then subtracted from the total sales.
1. Add any refunds or allowances offered to customers. For example, if a customer attempted to return a $500 item, but you offered to refund half the amount and allowed the customer to keep the product, then you have an allowance of $250.
2. Subtract the total returns and allowances from the total sales. If you produced $40,000 in sales, but paid out $5,000 in allowances, then your net receipts would be $35,000.
3. Subtract the cost of the goods sold from the figure in Step 2 to calculate gross profit. If the total cost of all items sold was $20,000, then you would have a gross profit of $15,000.
4. Divide the gross profit by the net receipts to calculate gross profit margin. Continuing with the example, $15,000 divided by $35,000 gives a gross profit margin of 0.4286, or 42.86 percent.
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