Gross Profit Margin

The gross profit margin is the ratio that calculates the company's profitability after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It does not include any other expenses except the cost of goods sold.

The discussion of what a good gross profit margin percentage depends on the industry of the business or the nature of sales. However, as a rule of thumb, it is considered that a 10% gross profit margin is good, 5% is low, and Over 10% is considered high retention of gross profit.

• The gross profit margin is the ratio that determines the company's profitability after writing off the direct cost of goods sold from the revenue.
• It may be expressed as a percentage of sales. Therefore, it does not involve other expenses except the cost of goods sold. 
• The gross profit margin formula includes gross profit and revenues.
• It is helpful to investors to compare it with similar companies by calculating the percentage

Gross profit margin is the amount retained by an organization after its sales. The gross profit percentage gives the company an idea of its costs and their profit percentage. It is an important metric for them to keep a close eye on to ensure their profitability is in check and its growth plan can be curated accordingly.

Thus, gross profit margin equation is a metric that helps in evaluation of the profitability of the company which also lead to the assessment of efficiency levels in utilizing the assets and other resources in generating revenue. The better the production process with respect to cost control and rising sales, the higher is the margin. This indicates that the financial health of the company is good, and any investment in it may lead to healthy returns in the future, assuring it sustainability.

However, gross profit margin percentage does not only depend on the internal condition of the business.  Many external factors, like changing market trends, interest rate conditions, inflation, or any sudden calamity, be it natural or man-made, can influence this metric. It varies across industries, product types, and operational processes.

In the gross profit margin formula, there are two components.

Let us understand the gross profit margin equation that is commonly used to calculate the gross profit margin of a business.

The formula to calculate gross margin and be able to carry out gross margin interpretation is-

Gross Profit Margin Formula = Gross Profit/ Revenue

Correct interpretation of the metric is essential in order to be able to use it properly in financial analysis.

If the margin for a business is high, the company is considered to have a profitable and sustainable future. It is a sign of financial health and denotes good and efficient production process. It has the ability to improve its sales figures further and actively compete in the market.

But if the gross profit margin percentage shows a low value, the investors and analysts should be concerned about the long term performance of the business. There is every possibility of it not being able to remain in the competition, if the margin is consistently low. It is necessary to do good research and gather the necessary information to evaluate its current data about its current performance and only then take investment decisions.

Since external factors also play some role in the entire process, it is important to consider them too, when making interpretation. However, a fundamentally strong company will have good strategies and policies in place so that any external factor is not able to have a very heavy negative effect on the overall performance of the company.  

Let us understand the concept of finding gross profit percentage with the help of a couple of examples.

Example #1

Honey Chocolate Ltd. has the following information in its income statement: -

• Net Sales - $400,000
• Cost of Goods Sold - $280,000

Find out the year's gross margin.

First, we need to find out the gross profit of Honey Chocolate Ltd.

Here is the calculation: -

• Gross Profit = (Net Sales – Cost of Goods Sold) = ($400,000 - $280,000) = $120,000.

Using the gross profit margin formula, we get: -

• Gross Margin = Gross Profit / Revenue * 100
• Or, Gross Margin = $120,000 / $400,000 * 100 = 30%.
• From the above calculation for the gross margin, we can say that the gross margin of Honey Chocolate Ltd. is 30% for the year.

To interpret this percentage, we need to look at other similar companies in the same industry.

Example #2

Let us calculate Colgate’s gross margin. Colgate’s Gross Margin = Gross Profit / Net Sales.

Cost of operations includes the depreciation related to manufacturing processes (Colgate 10K 2015, pg. 63).
Shipping and handling prices may be reported in the cost of sales or selling general and admin expenses. Colgate said these as a part of selling general and admin expenses. Suppose charges are included in the cost of sales, the gross margin of Colgate decreased by 770 bps from 58.6% to 50.9%. It may fall by 770bps and 750 bps in 2014 and 2013, respectively.

source: – Colgate 10K 2015, pg 46

You can use the following calculator: -

Let us now do the same example of a gross margin calculator.

It is very simple. You need to provide the two inputs of gross profit and revenue.

Then, you can easily calculate the gross margin in the template provided.

You can download this template here - Gross Profit Margin Excel Template.

Profitability is an important factor to consider for investors. Investors look at mainly net profit margin along with gross margin. The gross profit margin calculator is useful to investors because they can easily compare it with other similar companies by calculating the percentage.

Comparing the gross profit percentage of all similar companies in the same industry provides the investors with the knowledge of whether the target company's gross profit is healthy. The better the gross profit percentage, the better the company's overall health and profitability. However, every investor should look at all the financial ratios before concluding.

There are ways and means to improve the margin which are effective but complex, and time consuming. However, if the business is serious about improvement, it should do the following consistently to get a good gross profit margin.

• Pricing - It is necessary to fix proper prices of its goods and services. Prices are based on the proper product value and how much useful it is for the consumers. In other words, how high its demand is and how convenient and it is in solving customet problems. Therefore, the prices should be competitive but bring the best level of value for the business.
• Proper product mix – The business should have a proper mix of products and services that are in line with the main business. There should not be any good that are consuming resources and production cost but not bringing much revenue, perhaps due to low demand or complexity in usage. This will raise cost but not sales. Business should try to eliminate sucg products from its product mix.
• Differentiation – Every business should be able to differentiate its goods and services from its competitors either in the form of utility or price or availability or brand image, etc. Only then it is possible to create a market with loyal customers who will think twice before switching to competitors and get a good gross profit margin.
• Customer base – The cmapny should try their best to increase the customer base as far as possible so that they can reach out to more people and get a higher market share. This increases revenue from sales and in turn increases the gross profit margin.

Therefore the above are some ways in which the entity can try to improve its margin and move towards a bright and competitive future.  

Both the above are financial metrics that are used to measure the profitability of a business. But there are some differences between them as follows:

• The most important difference lies in the formula of both. The former is calculated by dividing the gross profit by the revenue earned whereas the latter is calculated by dividing the operating profit by the revenue earned.
• The former shows how high revenue the company is able to earn from direct material or labor that are involved in the production process and the latter show how much revenue the company earns after taking away all overhead expenses like rent, payroll, utilities, etc.
• The former’s main focus is the production process and it efficiency level which leads to successful pricing strategies, whereas the latter focuses on the core operations by accounting for operating expenses.
• In the income statement format, the gross profit comes first and later on comes the operating profit.

Thus, the above are some important differences between them. It is necessary to understand them clearly so that the user of financial statement can interpret it properly and use it for correct decision  making both for corporate or for individual purpose.

This article is a guide to Gross Profit Margin and its meaning. We explain the formula, calculator, differences with operating profit margin & example. Here are the other suggested articles: -

• Calculate Profit Percentage
• Gross Profit Formula
• Gross Profit
• Net Profit Margin Calculator