The gross profit margin is helpful in determining how well a company is generating revenue from the costs involved in producing their goods and services. Gross profit margin is the percentage of revenue that exceeds the cost of goods sold. The higher the percentage, the more efficient the company's management is in generating profit for every dollar of the direct costs involved. In order to determine what's not included in the gross profit margin, we must first look at what goes into calculating gross profit.
Gross profit is the income a company earns after taking out the costs associated with producing and selling its products. Gross profit is shown as a whole dollar amount and is calculated by:
Gross profit = Revenue - Cost of Goods Sold
Gross profit margin is the percentage of profit generated from revenue and the costs involved in production. Gross profit margin is calculated as shown below:
What's in Gross Profit Margin and What's Not
As we can see above, the two components of gross profit and, ultimately, gross profit margin are total revenue and cost of goods sold. Revenue is the total income generated for a period. Revenue is also called net sales since it can have discounts and deductions taken out of the total because of returned merchandise. Revenue sits at the top of the income statement and, as a result, is referred to as the top line number for a company.
The cost of goods sold or COGS is the amount of direct costs and direct labor costs a company must pay to produce its goods.
Below are some of the costs in COGS:
- Direct materials
- Direct labor
- Equipment costs involved in production
- Utilities for the production facility
- Shipping costs
As a result, gross profit only includes the costs directly tied to the production facility, while non-production costs like company overhead for the corporate office is not included. The example below illustrates what's included in gross profit margin, and what's not.
- Total revenue (in green) was $2.67 billion, while the COGS was $1.7 billion (in red).
- Gross profit margin was 36% OR ($2.67 - $1.7 COGS) / 2.67 = .36 X 100 = 36%
- Operating expenses and overhead, which are listed as selling, general, and administrative (SG&A), are listed below COGS and go into calculating operating income, which came in at $3 million for the period (highlighted in blue).
- As a result, we can see that depreciation, amortization, and overhead costs (SG&A) were not included in gross profit margin for JC Penney.
There are exceptions whereby a portion of depreciation could be included in COGS and ultimately impact gross profit margin.
For some companies, the source of the depreciation expense determines whether the expense is allocated as cost of goods sold or as an operating expense. Some depreciation expenses are included in the cost of goods sold and are therefore captured in gross profit.
For example, a portion of depreciation on the manufacturer's plant and equipment might be included in the overhead costs or fixed costs for the plant. Since the plant and equipment are directly tied to producing the goods for the company, the depreciation for those fixed assets might also be included in COGS and be included in gross profit and gross profit margin.
The Bottom Line
Gross profit margin is an important metric in helping to identify how well a company is performing. However, there are other measures of profitability, including operating profit margin and net profit margin.
Operating profit margin includes indirect costs such as overhead and operational expenses. Net profit margin is the percentage of profit earned after all expenses are deducted, including taxes, interest payments, and any extra expenses not deducted in the calculations of gross profit margin or operating profit margin.
For more on profit margins, please read "What's the Difference Between Gross Profit Margin and Operating Profit Margin?" and "What's the Difference Between Gross Profit Margin and Net Profit Margin?"