Gross profit margin is a ratio that compares a company's profits to its revenue. A low profit margin reflects a dependency on consistently high sales volume for survival, while a company with a higher profit margin can better withstand fluctuations in sales volume.
Learn how to calculate the gross profit margin, and how you can use the ratio to assess businesses.
What Is Gross Profit Margin?
The gross profit margin is the ratio between a company's profits and its total revenue. In other words, the gross profit margin tells you how much money the company actually gets to keep for every dollar in revenue it earns. This figure tells analysts how heavily a business relies upon consistent sales volume.
The two aspects of a gross profit margin are gross profit and revenue. The revenue is a simple concept—that's how much money the company brings in through sales. Gross profit is a bit more complex because it requires an extra step (though most balance sheets and other financial documents will do the work for you). To get gross profit, an analyst must subtract the cost of goods sold (COGS) from total revenue.
- Alternate name: gross margin ratio
How Do You Calculate the Gross Profit Margin?
The formula for calculating the gross profit margin is easy. Simply take the gross profit and divide that by revenue.
How Gross Profit Margin Works
To better understand how the gross profit margin works, consider these two hypothetical examples.
Good Shoe Co. sold $30,000 in one month. The cost of goods sold was $15,000. This product's gross profit is $15,000.
Fine Shoes Inc. sold $20,000 in one month, but the cost of goods sold was only $5,000. The gross profit for Fine Shoes Inc. is $15,000.
Even though Fine Shoes Inc. made fewer sales than Good Shoe Co., the two companies had the same profit. In other words, Fine Shoes Inc. has a better gross profit margin.
There could be many reasons for this as there are many factors that contribute to profit margins. Fine Shoes may have had a better relationship with its supplier, so the inventory could have been cheaper. Good Shoe Co. might have more employees, so the payroll costs could take a more significant bite out of its profits.
Markdowns and sales promotions are more examples of how a company could reduce its gross profit margin. Anytime you sell the item for less than the initial markup (IMU), you are cutting into your margins. This is why it's important to use tools like open-to-buy systems. They keep you from having too much inventory so you can avoid having to discount your prices to get rid of the excess inventory.
Limitations of Gross Profit Margin
Gross profit margin is just one way of measuring profit margins. To better understand a company's financial standing, analysts should compare gross profit margins to the net profit margin and the operating profit margin.
The gross profit margin ratio works best when comparing two similar operations. Perhaps the most effective application is when a business owns multiple locations. The costs associated with sales should be roughly identical across stores, so any fluctuations in the gross profit margin should signal an issue that can be fixed.
However, many small business owners don't have a chain of retail stores they can assess with individual profit margin calculations. It gets a bit trickier when comparing two different companies that operate in the same industry.
The gross profit margin loses almost all of its assessment value when comparing costs across industries. Even comparing retail stores loses value when they aren't selling the exact same thing. A computer store will have different gross profit margins than a shoe store, but that doesn't tell analysts anything meaningful. Even if the computer store has a lower gross profit margin, that doesn't mean that it's operating inefficiently, or that the shoe company is a better business.
- The gross profit margin is a ratio that compares gross profit to revenue.
- The higher a company's gross profit margin, the less it relies on consistently high sales volume for survival.
- The gross profit margin is most effective when comparing very similar companies, and it loses most of its assessment value when comparing vastly different companies.