The Meaning and Use of Gross Profit Margin
This Calculation Gives You an Insight Into Profitability
Gross profit margin is a ratio that indicates the performance of a company's sales and production. This ratio is made by accounting for the cost of goods sold—which include all costs generated to produce or provide your product or service—and your total revenue. If your business has a gross profit margin of 24%, it means that 24% of your total revenue became profit.
A higher gross profit margin indicates efficient processes in a company. A lower ratio indicates your processes may not be as efficient as they could be.
You can also use the gross profit margin to look at the effectiveness of individual products or services. The gross profit of one product divided by the total revenue generated by that product will display the efficiency of the process.
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 = (net sales—the cost of goods sold) ÷ net sales
For example, a company may have sales revenue—net sales—of $75 million and a cost of goods sold of $57 million. So, in this instance, the calculation is:
Gross Profit Margin = ($75M—$57M) ÷ $75M = 0.24, or 24%
To fully understand what this calculation means, it may require more detailed explanations of the components involved.
Revenue includes sales and any other income from interest, rental properties, royalties, or any other generated income from the activities of the business.
Net sales are used in the equation, rather than total revenues, because net sales account for returns, allowances, and any discounts. Total revenues do not include these additional figures. However, you can use total revenues in place of net sales, but it will not give you as accurate a ratio as net sales do. The calculation for net sales is:
Net sales = Total revenues—(returns+allowances+discounts)
Cost of Goods Sold
The cost of goods sold (COGS) is the sum of all the costs of selling your products or services. These costs vary by business and industry. Both variable and fixed costs can be included in the COGS calculation. As the name implies, the variable cost can and will change as a result of increases or decreases in production. These items include the cost of raw material. Conversely, regardless of it the presses run full-tilt or sit idle, fixed cost will remain static. An example of a fixed cost is the mortgage or rent of a manufacturing plant.
Determining which costs to include in your COGS depends upon the industry your business operates in.
Direct labor—the labor directly associated with the product or service—is included. Costs related to sales, marketing, and buildings or facilities are not included in your COGS. General company expenses are not part of the COGS.
However, any cost that is directly related to products or services can be included in the cost of goods sold. While this may seem contradictory, it allows you to be flexible in determining your COGS due to the uniqueness of your business.