What Is Gross Profit Margin?
Gross profit is the amount remaining after deducting the cost of goods sold (COGS) or direct costs from revenue. Gross profit margin is a measure of a company’s profitability. It is usually calculated as a percentage of revenue. The cost of goods sold is a measure of the direct costs required to produce a good or service, like materials and labor. However, it excludes indirect expenses like distribution costs, marketing, and accounting. This makes the gross profit margin most useful as a percentage of sales when tracking the direct cost of operations.
Other profit ratios, such as net profit margin, reflect different measures of profit. While the gross margin is a useful measurement of profitability. However, the net profit margin includes a company’s total expenses. As a result, it is even more specific. Net profit is closely scrutinized by analysts and investors.
The Gross Profit Margin Formula in Percentage Terms
Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales x 100
Revenue refers to sales and all other income. This includes 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. This is because net sales are adjusted for returns, allowances, and any discounts. Total revenues do not include these adjustments. It is accepted accounting practice to use total revenues in place of net sales. However, it will not give you an accurate ratio as net sales provide.
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. Fixed costs, on the other hand, will not change whether in full production or sitting idle. 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.
A company’s gross profit margin percentage is calculated by first subtracting the cost of goods sold from the net sales. Net sales are gross revenues minus returns, allowances, and discounts. The result is then divided by net sales, to calculate the gross profit margin as a percentage.
For example, Melania’s Boutique reported $10 million in total revenue for the year. Melania’s cost of goods sold was $9 million — including fixed costs, materials costs, and labor costs. Using the Gross Profit Margin formula above, you can calculate Melania’s gross profit margin:
($10 million – $9 million) / $9 million x 100 = 12.5 percent
Generally speaking, a boutique with a gross profit margin of 12.5 percent is considered financially healthy. Profit margins for retail clothes are generally within a range of 4 percent to 13 percent according to industry analysts. Each industry has a different gross profit margin rate that’s considered positive.
What Does the Gross Profit Margin Tell You?
If a company’s gross profit margin wildly fluctuates, this may signal poor management practices or inferior products. On the other hand, such fluctuations may be justified in the case of a new start-up. Also, in cases where a company makes operational changes. Depending on the circumstances, temporary volatility may not be any cause for alarm. For example, if a company decides to automate certain supply chain functions, the initial investment may be high. However, the cost of goods should ultimately decrease due to the lower labor costs. Introducing automation is just one example where costs might temporarily fluctuate. It is worth verifying that eventually the costs eventually decline.
Product pricing adjustments may also influence gross margins. All things being equal, if a company sells its products at a premium, it should realize a higher gross margin. But, if a company sets its prices too high, fewer customers may buy the product. As a result, the company may gradually lose market share.
Price Adjustment to Boost Gross Profit Margin – Example
Analysts use gross profit margin to compare a company’s business model with that of its competitors. For example, Company A and Company B both produce a product with similar characteristics and levels of quality. If Company A finds a way to manufacture its product for 25% less, it will command a higher gross margin. This is because of its reduced costs of goods sold. As a result, Company A would have a competitive edge in the market. Company B, in an effort to make up for its loss in gross margin, counters by increasing its sales price 25%. Company B’s attempt to increase its revenue is dangerous and may even backfire. If customers walk away because of the higher price tag, Company B could lose both gross margin and market share.
Should the Profit Margin Be High or Low?
Bigger is better, right? A higher margin usually means that there is more available to invest, save, and cover indirect expenses. A higher gross profit margin indicates that a company is making more profit on sales. It is, therefore, more efficient at converting raw materials into income. A lower profit margin usually means that a company is less efficient at converting raw materials into income. As a result, it is making less profit from its sales.
Many investors and analysts use gross profit margin to gauge a company’s profitability in order to compare it with competitors. The percentage is also used to track a company’s progress over time. A higher margin can indicate increased efficiency and greater earning potential. As a result, investors may be willing to pay more for companies with higher profit margins. Of course, this assumes all other things are equal and the companies are in the same industry.
What Is a Good Gross Profit Margin?
The definition of a “good” varies by industry. Generally speaking, 5% is low, 10% is average, and 20% is considered a “good” gross profit margin. However, there is an overview of average gross profit margins you can refer to across various industries.
What Does a Low Gross Profit Percentage Mean?
A lower (or decreasing) gross profit margin indicates that a company is creating less gross profit from its revenue. It is, therefore, less efficient at turning raw materials and labor into income. This means that it has less money to put towards savings, operations, and/or indirect expenses. It may indicate that there are problems within the company, such as overpriced production or underpriced products.
Gross Profit Margin – Advantages and Disadvantages
Every financial ratio has its pros and cons. There are a number of reasons why the gross profit margin can be a useful metric. There are also some potential disadvantages as well.
Advantages
- Simple and Straightforward – This calculation provides a wealth of information. It indicates cost efficiency and helps companies track performance over time.
- Pricing Target – Using the profit margin as a guideline, companies can adjust their pricing strategies to optimize operations.
- Benchmark – This measure allows companies to compare performance to industry averages and competitors.
- Identify Potential Areas for Improvement – By highlighting the effectiveness of individual products or services, the gross profit margin can help companies identify areas for potential improvement.
Disadvantages
- Direct Costs Only – Doesn’t include all costs. This metric doesn’t account for costs such as taxes, marketing, accounting, and more (which limits its applications).
- Each Industry is Different – Costs, profits, and margins vary greatly between industries, which could make it tough to set benchmarks or compare to other companies.
- Potentially Misleading – Profit margins measure profitability but they don’t always reflect underlying activities. For example, some companies reduce their prices to increase their market share or spend more on production costs to secure a supplier.
The Gross Profit Margin should not be relied on solely. It should be combined with other metrics. Since gross profit margin only considers production costs, it’s not always the most accurate indicator of profitability. For accuracy, companies and analysts should use it in combination with other metrics.
Gross Profit Margin vs Gross Profit
The main difference is that gross profit is a value, whereas gross profit margin is a percentage.
- Gross profit is a numerical value – It indicates how much revenue a company has after deducting the costs of production. It is calculated by subtracting the cost of goods sold from revenue, which shows the amount that can finance indirect expenses and investments.
- Gross profit margin is a ratio or percentage – It indicates the gross profit as a percentage of revenue and is calculated by dividing gross profit by revenue. This percentage value indicates the proportion of revenue that is not consumed by the direct costs of producing the goods or services for sale. It indicates how efficiently the company generates gross profit from revenue. The higher the margin, the more a company earns for each dollar spent on production.
Net Vs Gross Profit Margin
Gross profit margin and net profit margin are both measures used to calculate the profitability of a company. But, there is one key difference:
- Gross profit margin is a measure of the proportion of revenue left after accounting for production costs. It illustrates how much profit a company earns in relation to each dollar spent on production. It is calculated by dividing gross profit (revenue – COGS) by revenue.
- Net profit margin, on the other hand, is a measure of the proportion of revenue left after ALL expenses are accounted for. This metric indicates how each dollar of revenue translates into profit. It is calculated by dividing net profit (gross profit – operating expenses and all other expenses) by revenue.
Final Words
Calculating gross margin allows a company’s management to better understand its profitability in a general sense. But it does not account for important financial considerations like administration and personnel costs, which are included in the operating margin calculation. These indirect costs can also impact a company’s profit, if not managed properly. Often administration and personnel costs are the first areas where management will make cutbacks. This is because administrative reductions are less likely to affect a company’s core operations, which are vital to the survival of a business.
A company’s gross profit margin is the most basic measure of a company’s profitability. It identifies how much money is left after accounting for the cost of producing goods and services and paying workers. Businesspeople and investors generally hope to see a stable or growing gross profit margin. When this margin is shrinking, either the business is investing in its operations or it has a problem. Generally speaking, gross margins remain fairly stable throughout a company’s lifetime. Significant fluctuations can be a potential sign of fraud, accounting irregularities, mismanagement, or increases in the cost of raw materials.
Up Next: Net Income Formula – What is Net Income?
Net Income Formula: Net income (NI) equals revenues minus expenses, interest, and taxes. It shows how much is left after all expenses are paid.
Net income (NI), is also called net earnings. It is calculated by taking total sales and subtracting the expenses necessary to generate sales. For example, the cost of goods sold, selling, general and administrative expenses, operating expenses, depreciation, interest, taxes, and other expenses. Investors use net income to determine if and how much the revenue exceeds the expenses of an organization. The number is listed on a company’s income statement and is also an indicator of a company’s profitability.
