Formula and What It Tells You

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What Is Gross Profit Margin?

Gross profit margin is a financial metric used by analysts to assess a company’s financial health. It’s the profit remaining after subtracting the cost of goods sold (COGS).

Gross profit margin shows the money a company makes after accounting for its business costs. This metric is usually expressed as a percentage of sales and is also known as the gross margin ratio. A typical profit margin falls between 5% and 10% but it varies widely by industry.

Key Takeaways

Gross profit margin is an analytical metric calculated as a company’s net sales minus the cost of goods sold (COGS).
It’s often expressed as the gross profit as a percentage of net sales.
The gross profit margin shows the profit made before deducting selling, general, and administrative costs which are considered when calculating the firm’s net profit margin.
Gross profit reflects a company’s total profit after deducting the costs of doing business.

How Gross Profit Margin Works

Gross profit is a company’s total profit after deducting the cost of doing business, specifically its COGS. It’s expressed as a dollar value. Gross profit margin is this profit expressed as a percentage.

Gross profit margin is one of the key metrics that analysts and investors use to assess a company’s financial health and efficiency. Companies use gross profit margin to identify areas for cost-cutting and sales improvement. A high gross profit margin indicates efficient operations. A low margin suggests areas needing improvement.

Product pricing adjustments may influence gross profit margins. Selling products at a premium typically increases gross margins. High prices may reduce market share if fewer customers buy the product, however. This can be a delicate balancing act, requiring careful management to avoid losing customers while maintaining profitability.

Fast Fact

Fluctuating margins might indicate poor management or product issues but they can also reflect justified operational changes such as initial high costs for automation that eventually reduce overall expenses.

Temporary volatility shouldn’t be a concern. The initial investment in automating supply chain formations might be high but the cost of goods will eventually decrease due to reduced labor costs associated with the automation.

Formula and Calculation of Gross Profit Margin

A company’s gross profit margin is calculated using this formula:

$\begin{aligned} &\text{Gross Profit Margin}=\frac{\text{Net Sales }-\text{ COGS}}{\text{Net Sales}}\\ \end{aligned}$

First, subtract the COGS from a company’s net sales. This is its gross revenues minus returns, allowances, and discounts. Then divide this figure by net sales to calculate the gross profit margin as a percentage.

Important

Analysts use a company’s gross profit margin to compare its business model with its competitors. Business owners must understand not just gross profits but also other profit margins as well such as operating profit margin and net profit margin. This will help them assess their business’s profitability after accounting for costs like inventory, salaries, and rent.

Gross Profit Margin vs. Other Margins

Gross profit margin is among the key profitability metrics that analysts and investors watch. The other two are net profit margin and operating profit margin.

Net Profit Margin

Net profit margin is a key financial metric that indicates a company’s financial health. It’s also known as net margin. It shows the profit generated as a percentage of the company’s revenue. Net profit margin is the ratio of its net profit to its revenues.

Management can use the net profit margin to identify business inefficiencies and evaluate the effectiveness of its current business model.

Subtract the COGS, operating expenses, other expenses, interest, and taxes from its revenue to calculate a company’s net profit margin. Then divide this figure by the total revenue for the period and multiply by 100 to get the percentage.

Operating Profit Margin

A company’s operating profit margin or operating profit indicates how much profit it generates from its core operations after accounting for all operating expenses.

Subtract the cost of goods sold (COGS), operating expenses, depreciation, and amortization from total revenue to calculate the operating profit margin. You then express the result as a percentage by dividing by total revenue and multiplying by 100, similar to gross and net profit margins.

Example of Gross Profit Margin

Assume that Company ABC and Company XYZ produce widgets with identical characteristics and similar quality levels. Company ABC will command a higher gross margin due to its reduced cost of goods sold if it finds a way to manufacture its product at one-fifth of the cost.

This gives Company ABC a competitive edge in the market. Company XYZ decides to double its product price to compensate for its lower gross margin and boost revenue. This strategy by Company XYZ has a potential downside, however: It might backfire if customers are put off by the higher price. Company XYZ could lose both gross margin and market share in this case.

What Does Gross Profit Margin Indicate?

A company’s gross profit margin indicates how much profit it makes after accounting for the direct costs associated with doing business. It can tell you how well a company turns its sales into a profit. It’s the revenue less the cost of goods sold which includes labor and materials and it’s expressed as a percentage.

What’s the Difference Between a High and Low Gross Profit Margin?

Companies strive for high gross profit margins because they indicate greater degrees of profitability. It means that a company operates efficiently when it has a higher profit margin. It can keep itself at this level as long as its operating expenses remain in check.

A lower gross profit margin is a cause for concern. It can impact a company’s bottom line and it means that there are areas that can be improved.

How Does a Company Increase Its Gross Profit Margin?

A company can increase its gross profit margin and its profitability in several ways. These include:

Reducing its operating expenses without lowering sales prices
Increasing its prices without increasing the cost of doing business
Improving its productivity and efficiencies
Relying on its existing customers to increase its average order value

The Bottom Line

It’s smart for investors to look at key financial metrics so they can make well-informed decisions about the companies they add to their portfolios. One important metric is the gross profit margin which you can calculate by subtracting the cost of goods sold from a company’s revenue. Both figures are available on a company’s income statement.

A higher gross profit margin indicates a more profitable and efficient company. Comparing companies’ margins within the same industry is essential, however, because this allows for a fair assessment due to similar operational variables.

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Formula and What It Tells You