What is Gross Profit Margin
Gross profit margin is a financial metric used to assess a company's financial health and business model by revealing the proportion of money left over from revenues after accounting for the cost of goods sold. One can calculate gross profit margin, also known as gross margin, by dividing gross profit by revenues.
Understanding Profit Margin
BREAKING DOWN Gross Profit Margin
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. 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.
Driving Gross Margin
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, customers may not buy the product.
Gross Profit Margin Example
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.