The Meaning and Use of Gross Profit Margin

The gross profit margin calculation gives you an insight into profitability

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Gross profit margin is a financial calculation that can tell you, in percentage terms, a good deal about a company's overall financial health. It reveals how much money is left over, after paying for production, to cover operations, expansion, debt repayment many other business expenses. 

A company's gross profit represents the revenue dollars remaining after deducting all costs relating to the sale of those goods.

It's the numerator in the gross profit margin equation, while the denominator is the revenue from sales minus the cost of goods sold.

The Gross Profit Margin Calculation

Gross profit margin is the percent of revenues that remain after deducting the cost of goods sold: 

Gross Profit Margin = (revenue from sales minus cost of goods sold) ÷ revenue from sales

For example, a company may have sales revenue of $75 million and a cost of goods sold, explained in detail below, of $57 million. So in this instance, the calculation is:

Gross Profit Margin = ($75M-$57M) ÷ $75M = .24, or 24% 

Getting the full benefit of this calculation, which in itself is quite simple, requires an understanding of the exact meaning of its components.

Different Types of Revenue

Revenue, for most companies, is pretty much the same thing as sales. However, an important difference between the two is that revenue is the more comprehensive term.

It includes sales but also includes any other income, such as that from interest, rental properties, royalties or, in fact, almost anything else that produces non-sales income.

This distinction is one of the reasons that the gross profit margin calculation is a good approximate gauge of company health, but cannot be entirely accurate in certain cases.

When calculating a gross margin ratio and analyzing the result, it's important to know if you're using total sales or total revenue. 

If, for instance, a pharmaceutical company has licensed a drug to another company, in the first year of the drug's release it may receive very large royalty payments. This non-sales revenue is a big change from other years, and so distorts the expectable revenue in future years.

In such cases, a forensic accountant, a professional looking deep into a company's finances, might add a note to the company's revenue statement. They would point out that future revenue streams from royalties will taper down year after year at some relatively predictable rate and then, upon the expiration of the drug's patent, will sharply decline. In this case, using total revenue in the gross profit margin equation returns a different answer, and different view of the company, than using strictly sales revenue.

What Is Cost of Goods?

Cost of goods sold (COGS) refers to a company's variable costs only. This explains why the gross margin calculation, although useful, doesn't tell you all you need to know to determine how well a company is doing.

Variable costs include actual production costs such as wages, materials, sales commissions and other expenses that vary with production output, such as credit card fees associated with sales.

These costs are only relevant to, and driven by, the revenue that comes from sales of the company's product or service, rather than revenue from other sources like interest income.

COGS does not, however, include fixed costs such as rent, payments to salaried employees (as distinguished from production workers who are paid hourly) and any and all expenses related to the physical plant. In most cases, where these fixed costs are within normal bounds, excluding them slightly increases the accuracy of the gross profit margin calculation because it gives you a better handle on the company's costs directly related to producing the product.

In some instances, excluding fixed costs from this equation can provide a misleading picture of profit margins. A manufacturing company renting premises in a fast-growing, up-and-coming area, may have escalating and finally unsustainable rent increases, but this won't be reflected in the gross margin because rent is a fixed cost.

Despite its limitations, however, the gross margin calculation is a useful way to track profitability. 

Increasing Your Gross Profit Margin

Small business owners are always looking to improve their gross profit margins. In other words, they want to decrease their cost of goods sold while increasing sales revenues. 

One way of accomplishing this is to increase the price of your product. You have to be careful about doing this, particularly in a poor business climate. If you make a mistake and increase your prices too much, your sales can drop. In order to increase your prices successfully, gauge the economic environment, your competition, and the supply and demand for your product, along with any useful information you can gather about your customer base including incomes, spending habits, and credit preferences. 

You can also decrease the cost of making your product, meaning your variable costs. This is just as tricky as increasing the price of your product. You can make the product more efficiently. This might involve decreasing your labor costs, which could require layoffs or other cost-saving constraints impacting employee goodwill. If you decrease your labor costs in this way, it could affect the quality of your product.

Finally, you can decrease your manufacturing costs with regard to materials. You may want to try to find a supplier for materials that offers them at a less expensive price. You can also try to negotiate volume discounts with your current supplier.

If you buy materials in bigger bulk, the supplier may give you a discount. While looking for a supplier offering materials for a cheaper price, never lose sight of quality. The Takata airbag fiasco, which severely impacted revenue for Honda, an auto company that heretofore had an excellent reputation for quality, shows the danger of choosing product materials by using cost as the primary selection filter.