The gross profit margin is a baseline profitability ratio measurement against total sales revenue. The gross profit margin is primarily used by companies to examine fixed production and distribution costs, and secondarily to guide company decisions on variable costs to maximize real net profits.

The gross profit margin is the percentage of total sales revenue that remains after deducting direct production-related costs. The formula for calculating gross profit margin is simple:

Total sales revenue - production costs / total sales revenue

The resulting number is then expressed as a percentage. Direct production-related costs include costs of labor and parts used specifically in the process of manufacturing or producing the company's products for sale. These are commonly designated as fixed costs, since most manufacturing companies have long-term contracts for buying necessary parts at fixed prices. Although there is some variation over time, overall, a company's direct manufacturing costs are not expected to experience wide fluctuations from year to year.

Once a company knows its gross profit margin, it also knows how much money remains to cover variable costs of overhead and other operating expenses, taxes and interest due on financing. From the gross profit margin percentage, companies run analyses to help them maximize profitability. Companies use the gross profit figure to examine questions such as the following:

• Does the gross profit margin provide sufficient funds to cover all the other costs of doing business, while leaving an acceptable level of net profits?
• Can the company afford to take on additional debt financing?
• Does the sales price need to be increased to ensure adequate profitability?
• Are current fixed manufacturing costs too high to provide adequate gross profits?

The gross profit margin is the initial profitability calculation done by companies, followed by calculations of operating profit margin and net profit margin; the final calculation showing the percentage of sales revenues the company retains after accounting for its total costs of doing business.

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