What Is Gross Profit Margin?

Gross profit margin is a metric analysts use to assess a company's financial health by calculating the amount of money left over from product sales after subtracting the cost of goods sold (COGS). Sometimes referred to as the gross margin ratio, gross profit margin is frequently expressed as a percentage of sales.

Key Takeaways

  • Gross profit margin is an analytical metric expressed as a company's net sales minus the cost of goods sold (COGS).
  • 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.

The Formula for Gross Profit Margin

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

How to Calculate Gross Profit Margin

A company's gross profit margin percentage is calculated by first subtracting the cost of goods sold (COGS) from the net sales (gross revenues minus returns, allowances, and discounts). This figure is then divided by net sales, to calculate the gross profit margin in percentage terms.

What Does the Gross Profit Margin Tell You?

If a company's gross profit margin wildly fluctuates, this may signal poor management practices and/or inferior products. On the other hand, such fluctuations may be justified in cases where a company makes sweeping operational changes to its business model, in which case temporary volatility should be no cause for alarm.

For example, if a company decides to automate certain supply chain functions, the initial investment may be high, but the cost of goods ultimately decreases due to the lower labor costs resulting from the introduction of the automation.

Product pricing adjustments may also influence gross margins. If a company sells its products at a premium, with all other things equal, it has a higher gross margin. But this can be a delicate balancing act because if a company sets its prices overly high, fewer customers may buy the product, and the company may consequently hemorrhage market share.

An Example of Gross Profit Margin Usage

Analysts use gross profit margin to compare a company's business model with that of its competitors. For example, let us assume that Company ABC and Company XYZ both produce widgets with identical characteristics and similar levels of quality. If Company ABC finds a way to manufacture its product at 1/5 the cost, it will command a higher gross margin because of its reduced costs of goods sold, thereby giving ABC a competitive edge in the market. But then, in an effort to make up for its loss in gross margin, XYZ counters by doubling its product price, as a method of bolstering revenue.

Unfortunately, this strategy may backfire if customers become deterred by the higher price tag, in which case, XYZ loses both gross margin and market share.