Simply put, Gross Profit Margin is the percentage of revenue that turns into profit. It’s a simple calculation but a concept that’s easy to mix-up with other measures or to misuse. In this guide we’ll break down what Gross Profit Margin is, how it differs from other measures, and how you can use it to learn more about a business.
Here’s the basics: Looking at a profit margin rather than the raw profit figure shows how efficiently a company is operating, regardless of its size. Gross profit margin concentrates on the core business activity while net profit margin takes into account administration and other costs. Both figures provide insight but it’s best to compare them with figures for similar business.
Gross Profit Margin is a simple calculation, though the words used in it can vary. It’s simply:
(Revenue – Costs of Goods Sold) / Revenue.
In other words, subtract Costs of Goods Sold from Revenue and divide the result by Revenue.
Sometimes people will use different words to express the concepts in the calculation. Instead of “revenue”, you could use “sales”. Either way, it’s the money the business has made from selling goods and services.
“Costs of Goods Sold” is a specific term. It doesn’t mean all the costs a business faces, which is why it’s better not to simply write “costs” when explaining Gross Profit Margin. Instead “Costs of Goods Sold” specifically means those costs which are directly associated with producing the goods in question.
Most commonly this covers two types of spending: buying the raw materials used to make the goods, and paying staff for the work they do making the goods. (With services, usually only the staff costs apply.) It could also cover relevant transport costs.
“Costs of Goods Sold” excludes all sorts of other costs that aren’t directly associated with producing the goods. Examples include general operating expenses, management salaries, marketing costs and taxes.
Technically speaking, the Gross Profit Margin calculation will produce a fraction, such as 0.6. It’s almost always expressed as the corresponding percentage — in this case 60 percent.
The calculation for Gross Profit Margin might seem a bit unintuitive, particularly as “Revenue” appears twice. It makes more sense when you understand what the figure is meant to represent.
In simple terms, it shows what proportion of the revenue from the goods is left over as profit. Another way to look at it is that the higher the Gross Profit Margin, the more efficiently and effectively the company is performing in turning materials and labour into revenue.
If somebody gives their “profit” as a percentage figure, they won’t necessarily be referring to gross profit margin. Instead they might simply have divided the revenue by the costs and expressed the result as a percentage increase. This creates a risk of confusion.
For example, imagine a company spends $100,000 producing goods and then sells them for $250,000. It could simply note that $250,000 is 2.5 times bigger than $100,000 and thus conclude it has made a “return” or “profit” of 150%.
However, the correct gross profit margin calculation is ($250,000 – $100,000) / $100,000 with a result of 60%.
While both of these figures are technically true and are based on the same facts, they clearly are not comparable. “Gross profit margin” has a specific meaning, so you should always clearly use the term to show readers what the figure represents.
Gross Profit Margin vs Gross Profit
A company can also calculate its Gross Profit. This is simply the Revenue minus the Cost of Goods Sold (in other words, just the first step of the Gross Profit Margin calculation.)
Gross Profit is a raw figure – an amount of money — rather than a percentage figure, also called a margin. Both figures have their uses, but Gross Profit Margin can be more useful for assessing a company’s performance. For example, let’s take two rival companies:
Megawidget Corp has a Revenue of $2.2 million and Cost of Goods Sold of $2.0 million. That makes a Gross Profit of $200,000 and a Gross Profit Margin of 9.09%.
Startup Widgets has a Revenue of $130,000 and Cost of Goods Sold of $100,000. That makes a Gross Profit of $30,000 and a Gross Profit Margin of 23.07%.
Gross Profit shows Megawidget is making much more money from making and selling goods. However, Startup Widget has a much better Gross Profit Margin, meaning it’s turning materials and labour into sold goods much more efficiently.
A would-be investor might conclude StartUp Widget has the potential for huge profits if it can grow market share. Alternatively the investor might fear Megawidget would struggle to cover overheads if sales of widgets dropped.
Gross Profit Margin vs Net Profit Margin
Gross Profit Margin calculations intentionally leave out costs that don’t directly relate to producing goods. That’s in contrast to Net Profit Margin, which is simply:
(Revenue – All Costs) / Revenue.
In other words, Net Profit Margin takes account of the costs of running the business itself such as administration, management, marketing and so on. Many of these are fixed costs that don’t depend on the volume of sales.
Both figures are important for assessing the performance and potential of a business. Gross Profit Margin shows how well the company performs in its core business activity while Net Profit Margin covers the efficiency of the entire operation. Comparing the two can reveal how beneficial an increase in sales would be, or how well the company could withstand a drop in sales.
What’s A Good Gross Profit Margin?
There’s no simple threshold that counts as a good or bad Gross Profit Margin for businesses as a whole. It can depend on factors such as:
· How competitive the market is.
· Whether the business is based on high volume/low mark-up or low volume/high mark-up.
· Whether a company is growing or established.
Comparing the Gross Profit Margin of two randomly selected businesses likely won’t be very insightful. Instead it’s more useful when comparing two businesses in the same industry to see which is more efficient at production. Alternatively you can track how a company’s Gross Profit Margin changes over time to see if it is becoming more efficient.
If you’re still uncertain about Gross Profit Margin, you can break down the term to see how we build up the calculation:
Profit is the familiar concept: Revenue minus Costs.
Gross means that you only take into account the Revenue from selling goods and the direct costs of producing those goods. That gives us Revenue minus Cost of Goods Sold.
Margin means that you are looking at the profit as a percentage of revenue rather than a raw number. That gives us the complete calculation of:
(Revenue – Cost of Goods Sold) / Revenue.
Though a simple measure, Gross Profit Margin gives a very useful insight into a business. These are just a few of the questions it can help answer.
· How efficiently is the company performing its core activity?
· Does it make more sense to try to boost sales or diversify into more profitable product lines?
· How much effect would an increase or decrease in sales have on the company’s overall performance?
· Does the company have a fundamentally strong business model that’s being held back by excessive administration costs?
· Would a takeover make sense, for example by combining a small company’s efficient production methods with a larger company’s economies of scale for costs such as management and marketing?