Gross Profit Margin

Gross profit margin is a profitability ratio that determines the difference between the total sales of a company and the cost of goods sold. Put simply, the ratio highlights a company’s remaining profits after meeting its direct production cost – also known as the cost of goods sold (COGS).

A gross profit margin is a vital measure for investors as well as management as it enables them to easily make decisions about a company without having to necessarily research much about them.

For example, if investors see a company with a higher profit margin ratio, it will indicate that it is in a good financial position to produce as well as sell its products profitably.

On the other hand, if a company has a negative gross profit margin that will indicate they are making loses on production, and investors would have to rethink investing in the company.

Gross Profit Margin Formula

Gross\: Profit = Total\: Sales - Cost\: of\: Goods\; Sold

From the income statements, you can deduct the values of a company’s total sales as well as that of cost of goods sold, and use the two values to calculate the gross profit margin either as a percentage of the figure.

First, you will have to calculate the gross profit by subtracting the cost of goods sold by a company from its total sales.

Gross profit expressed as a value, as in the above case, is not that beneficial to many investors, and that is the reason why many companies put this ratio as a percentage.

To express the gross profit margin as a percentage, we will divide the gross profit value by total sales.

Gross\: Profit\: Percentage = \dfrac{ Total\: Sales - Cost\: of\: Goods\: Sold }{ Total\: Sales }

Each of the above methods could be used in the calculation of the gross profit margin and they would provide similar results that will be interpreted by investors in the same way.

Gross Profit Margin Analysis

Gross profit margin is important because it shows investors and company management how efficient the business is at producing and selling products, and how profitable it is.

Most companies tend to maintain a steady gross profit margin ratio. If the ratio increases or declines at an unusual rate, this could mean there are problems with the business such as an increase in the cost of raw materials or issues with distributing the product.

GP is also very useful to accountants or company management when creating budgets or forecasting potential future business activity. Let’s say the gross profit of a company is $300,000. This means that if they want to profitable next year, all costs and expenses must be less than $300k.

On the flip side, the company could view that $300k as money which can be invested in further growth, and could put a plan together with the accountants to do that as efficiently as possible.

The gross profit margin more useful to investors as a percentage because it allows easy comparison of companies regardless of their sizes and volumes. A tech startup gross profit margin of $300,000 can easily be compared to Google’s margin even though they are multi-billion dollar company. This quick view of how profitable a company’s core business activities are is very useful.

Analysis of gross profit margin among similar companies could be used in determining the overall gross profit margin rate for the industry, which will be a guiding factor before making investments decisions.

That said, it is important to note that the nature of some industries attracts higher sales and less operational costs, and these industries will have a higher gross profit margin. 

Companies could also use the gross profit ratio to monitor how effective some products or services are when compared to others. Displaying the efficiency of the product could help a business specialise in the production of a particular line or product with a higher return on investment.

For example, if a business is producing three products, it could easily calculate the gross profit margin of each of its products from its cost of goods sold and net sales determining ones with a higher return on investments.

Gross Profit Margin Example

Brandon runs a shoe company that has been performing well, and he wants to work out his gross profit margin in preparation for a meeting with investors. Here is what shows in the company income statement at the end of the year:

  • Total Sales: $ 1,200,000
  • COGS: $ 450,000
  • Rent: $ 300,000
  • Utilities: $20,000
  • Accrued expenses: $5,000

The company needs to determine its gross profit margin for its upcoming meeting with investors.

Gross\: Profit = \$1{,}200{,}000 - \$450{,}000 = \$750{,}000

Brandon’s GP is $750,000 and this money an be used to pay other bills, like rent and utilities, as well as to invest back into the company.

He can also work out the gross profit margin as a percentage: 

Gross\: Profit\: Percentage = \dfrac{ \$1{,}200{,}000 - \$450{,}000 }{ \$1{,}200{,}000 } = 62.5\%

Brandon can now use this percentage when talking to potential investors and say that the company has a gross profit margin of 62.5%. Put simply, for every dollar of sales generated, the company earns 62.5 cents in profit.

Conclusion

When working with gross profit margin ratios, the below points are worth bearing in mind as a quick recap of what it is, why it’s used, and how to use it:

  • Gross profit margin is the difference between the net sales and the cost of goods sold by a company
  • Gross profit can be shown as a whole number or as a percentage
  • The ratio shows the efficiency of a company when it comes to the production and selling of products, even though it does not take into account other expenses
  • Investors often prefer to see gross profit as a percentage because it is easier to compare against other companies.
  • Cost of goods sold and total sales figures are found in a company’s incomes statement

Gross Profit Margin Calculator

You can use the gross profit margin calculator below to work out your own GP using the required formula inputs.