Gross profit margin, also known as gross margin, is a financial metric that indicates how efficient a business is at managing its operations. It is a ratio that indicates the performance of a company's sales based on the efficiency of its production process.
Gross profit margin is a valuable financial measurement to company managers as well as to company investors since it indicates the efficiency with which the business can produce and sell one or more products before extraneous costs are deducted. Gross profit margin is based on the company's cost of goods sold. It can be compared to the operating profit margin and net profit margin depending on the information you want. Like other financial ratios, it is only valuable if the inputs into the equation are correct.
What Is Gross Profit Margin?
Gross profit margin is a financial ratio that is used by managers to assess the efficiency of the production process for a product sold by the company or for more than one product. A business may be more efficient at producing and selling one product than another. The gross profit margin can be calculated for each individual product as long as the business can differentiate the direct costs of producing each product from the others. The cost of goods sold on a company's income statement accounts for the direct costs of producing their products. Direct costs include those costs that are specifically tied to a cost object, which may be a product, department, or project.
The cost of goods sold is made up of the company's direct costs. Only direct costs are considered and not indirect costs. Direct costs are usually variable in nature. These variable costs change with the quantity of the product produced. Examples are direct labor which includes the work done by workers just on a particular product. Another direct cost is direct materials which might include the raw materials needed to produce the product.
Gross profit margin is most easily understood if it is expressed as a financial ratio, whereby:
- The cost of goods sold is compared to the company's net sales.
- Net sales, taken from the company's income statement, are total sales less any returns.
- The cost of goods sold, also taken from the income statement, are the direct costs of producing the company's product or products.
Only firms that manufacture their own products will have direct costs and, as a result, the cost of goods sold on their income statement. Firms that sell a service will typically have very low or no cost of goods sold.
Like other financial ratios, the gross profit margin is only meaningful on a comparative basis. The financial manager may want to use trend analysis to compare the gross profit margin to that of other time periods or industry analysis to compare it to other similar companies.
The financial manager may want to use trend analysis to compare the gross profit margin to that of other time periods or industry analysis to compare it to other similar companies.
Gross Profit Margin Formula
Gross profit margin is the percent of revenues that remain after deducting the cost of goods sold. Use this formula below:
After making the calculation, you will arrive at a percentage which is the company's gross profit margin.
How to Calculate Gross Profit Margin
The calculation for the gross profit margin has only two variables: net sales and cost of goods sold. Both numbers can be taken from the income statement of the company:
Net sales, or net revenue, is used in the equation because Total Revenue would not be accurate. You have to subtract any returns, discounts, and allowances from Total Sales to arrive at the net figure.
Cost of Goods Sold
Cost of goods sold (COGS) is the sum of the production costs of a company's product. It includes the direct costs of producing the product like direct materials and direct labor. Indirect costs are not included in the calculation. There is some room for variability in what costs go into the cost of goods sold calculation. It can vary with the industry in which the company operates. General company expenses like sales and administrative costs, marketing costs, and most fixed costs are not included in the cost of goods sold.
Example of Gross Profit Margin Usage
Since the gross profit margin ratio only requires two variables, net sales and cost of goods sold, for the calculation, you only need to look at a company's income statement.
Let's say XYZ, Inc. has $75 million in net sales and $68 million in cost of goods sold according to its latest income statement. What is the gross profit margin?
$75 million - $68 million/$75 million = .0933, or 9.33%.
The gross profit margin is 9.33% for XYZ, Inc.
This means that 90.67% of the firm's profits were used for the cost of goods sold or to manufacture the product that the firm produces, and 9.33% are left for other expenses and net profit for the company. You have to compare 9,33% to other years of firm data or other companies in the industry to determine what it means.
If the gross profit margin is much lower or higher than in other years of data, you want to find out the reason. If it varies wildly from other firms in the industry, you should check that out as well.
Good vs. Bad Gross Profit Margin Ratio
Small business owners must be able to interpret their company's financial ratios. Here are some of the interpretations of the gross profit margin ratio.
Company Production Efficiency
Gross profit margin is a measure of the efficiency of a firm's production process. A good, or higher, percentage gross profit margin is indicative of a company producing their product more efficiently. The financial manager can compare the gross profit margin to companies in the same industry or across time periods for the same company.
Company managers must look deeper for all factors contributing to gross profit margin.
Lower Efficiency in the Production Process
A lower percentage gross profit margin is indicative of a company producing their product not quite as efficiently. This would be determined if the gross profit margin is dropping across time or if it is lower than companies in the same industry.
A low sales volume might not cause the gross profit margin to also look low. However, if sales volume is not enough to cover other company expenses such as sales and administrative expense, then it doesn't matter what the gross profit margin is.
Poor Pricing Structure
A poor pricing strategy can cause gross profit margin to come in low.