What Is Gross Profit Margin?

Gross profit margin is a metric used to assess a company's financial health and business model by revealing the amount of money left over from sales after deducting the cost of goods sold. The gross profit margin is often expressed as a percentage of sales and may be called the gross margin ratio.

The Formula for Gross Profit Margin

Gross profit margin=Net sales - COGSNet sales\begin{aligned} &\text{Gross profit margin}=\frac{\text{Net sales - COGS}}{\text{Net sales}}\\ \end{aligned}Gross profit margin=Net salesNet sales - COGS

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Understanding Profit Margin

How to Calculate Gross Profit Margin 

Start calculating a company's gross profit margin percentage, also known as gross margin, by first finding its gross profit. Gross profit is equal to net sales revenue minus the cost of goods sold. Net sales is equal to gross revenue minus returns, allowances, and discounts. Divide gross profit by net sales to find the gross profit margin in percentage terms.

What Does the Gross Profit Margin Tell You?

There are several layers of profitability that analysts monitor to assess the performance of a company, including gross profit, operating profit, and net income. Each level provides information about a company's profitability. Operating profit, also known as net profit or net profit margin, shows the amount of revenue left after deducting selling, general, and administrative (SG&A) costs.

Gross profit, the first level of profitability, tells analysts how good a company is at creating a product or providing a service compared to its competitors. Gross profit margin, calculated as gross profit divided by revenues, allows analysts to compare business models with a quantifiable metric.

Without an adequate gross margin, a company cannot pay for its operating expenses. In general, a company's gross profit margin should be stable unless there have been changes to the company's business model. For example, when companies automate certain supply chain functions, the initial investment may be high; however, the cost of goods sold is much lower due to lower labor costs.

Industry changes in regulation or even changes in a company's pricing strategy may also drive gross margin. If a company sells its products at a premium in the market, all other things equal, it has a higher gross margin. The conundrum is if the price is too high, fewer customers may buy the product.

Key Takeaways

  • Gross profit margin can be expressed as net sales minus the cost of goods sold.
  • Gross profit margin is often shown as the gross profit as a percentage of net sales.
  • The gross profit margin shows the amount of profit made before deducting selling, general, and administrative costs, which is the firm's net profit margin.

An Example of How to Use Gross Profit Margin

Analysts use gross profit margin to compare business models with competitors. More efficient or higher premium companies see higher profit margins. For example, if you have two companies that both make widgets and one company can make the widgets for a fifth of the cost in the same amount of time, that company has the edge on the market.

The company has figured out a way to reduce the costs of goods sold by five times its competitor. To make up for the loss in gross margin, the competitor counters by doubling the price of its product, which should increase revenue. Unfortunately, it increased the sales price but decreased demand because customers did not want to pay double for the product. The competitor lost gross margin and market share.

Suppose ABC company earns $20 million in revenue from producing widgets and incurs $10 million in COGS-related expenses. ABC's gross profit is $20 million minus $10 million. One can calculate the gross margin as the gross profit of $10 million divided by $20 million, which is 0.50 or 50%. This means ABC earns 50 cents on the dollar in gross margin.