What is the Gross Profit Margin?
The Gross Profit Margin Calculation Gives You an Insight into Profitability.
Gross profit margin is a financial calculation that tells you a lot about a company's overall financial health. It reveals how much money is left over for operations, expansion, debt repayment, distributions to owners and shareholders and other miscellaneous expenses.
The Gross Profit Margin Calculation
Gross profit margin is the ratio of revenues remaining after deducting the cost of goods sold to revenues:
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 (which we'll get into further below) of $57 million. So in this instance, the calculation is:
Gross Profit Margin = ($75M-57M) ÷ $75M, which equals .24, or 24%.
Underlying Terms Explained
To get the full benefit of this calculation, which in itself is quite simple, requires your understanding of a the exact meaning of a few underlying terms:
Revenue, for most companies, is pretty much the same thing as sales.The difference between the two is that revenue is the more comprehensive term. It includes sales, but also any income from rental properties, royalties or, in fact, almost anything that produces 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 many cases.
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. These effectively distort the expectable revenue in future years. In such cases, a forensic accountant -- a professional looking deep into a company's finance -- might append a note to the revenue statement, pointing out that future revenue streams from royalties will come down year after year at some relatively predictable rate and then, upon the expiration of the patent, will sharply decline.
Nevertheless, although imperfect, revenue is what the gross profit margin equation uses, not sales along.
Gross profit is the revenue remaining after deducting all costs relating to the sale of those goods. It's the numerator in the gross profit margin equation above: revenue from sales minus the cost of goods sold.
Cost of goods sold refers to variable costs only. This is another reason that 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 including actual production costs, such as wages, materials, sales commissions and other costs that vary with production output, such as credit card fees associated with sales. It 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, exclusion of fixed costs from this equation can provide a misleading picture of profit margins.
A manufacturing company renting premises in Brooklyn, which has rapidly gentrified in the 21st century, may have growing, and finally unsustainable rent increases, but these will not show up in this particular financial metric.
Despite its limitations, however, the gross margin calculation is a useful way to track profitability.
How to Increase 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.
When 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, you have to 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 -- 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 in turn might involve 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 bulk, the supplier may give you a discount. When you are 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, a company that heretofore had an excellent reputation for quality, shows the danger of determining materials selection using cost as the primary criterion.
Further reading on profitability:
- Types of Profitability Ratios
- What is the operating profit margin ratio?
- Use Profitability Ratios in Financial Ratio Analysis