Gross Profit Margin: Formula and What It Tells You

What Is Gross Profit Margin?

The term gross profit margin refers to a financial metric that analysts use to assess a company's financial health. Gross profit margin is the profit after subtracting the cost of goods sold (COGS). Put simply, a company's gross profit margin is the money it makes after accounting for the cost of doing business. This metric is commonly expressed as a percentage of sales and may also be known as the gross margin ratio.

Formula and Calculation of Gross Profit Margin

A company's gross profit margin is calculated using the following formula:

$\begin{aligned} &\text{Gross Profit Margin}=\frac{\text{Net Sales }-\text{ COGS}}{\text{Net Sales}}\\ \end{aligned}$​Gross Profit Margin=Net SalesNet Sales − COGS​​

This requires first subtracting the COGS from a company's net sales or its gross revenues minus returns, allowances, and discounts. This figure is then divided by net sales, to calculate the gross profit margin in percentage terms.

How Gross Profit Margin Works

Gross profit is the total profit a company makes after deducting the cost of doing business. Put simply, gross profit is a company's total sales or revenue minus its COGS. This figure is expressed as a dollar value. Gross profit margin, on the other hand, is the profit a company makes expressed as a percentage using the formula above.

It is one of the key metrics analysts and investors watch as it helps them determine whether a company is financially healthy. Companies can also use it to see where they can make improvements by cutting costs and/or improving sales. The sales and COGS can be found on a company's income statement. A high gross profit margin is desirable and means a company is operating efficiently while a low margin is evidence there are areas that need improvement.

Product pricing adjustments may influence gross profit margins. With all other things equal, a company has a higher gross margin if it sells its products at a premium. But this can be a delicate balancing act because if it sets its prices overly high, fewer customers may buy the product. As a result, the company may consequently hemorrhage market share.

A wildly fluctuating margin may signal poor management and/or inferior products. But these changes may be justified when sweeping operational changes are made. As such, any temporary volatility shouldn't be a concern. For instance, the initial investment may be high if a company automates certain supply chain formations, but the cost of goods ultimately decreases due to lower labor costs associated with the automation.

Gross Profit Margin vs. Net Profit Margin vs. Operating Profit Margin

Gross profit margin is among the key profitability metrics that analysts and investors watch. The other two are net profit margin and operating profit margin

Net Profit Margin

Net profit margin is a key financial metric that also points to a company's financial health. Also referred to as net margin, it indicates the amount of profit generated as a percentage of a company's revenue. Put simply, a company's net profit margin is the ratio of its net profit to its revenues.

A company's management can use its net profit margin to find inefficiencies and see whether its current business model is working.

You can calculate a company's net profit margin by subtracting the COGS, operating and other expenses, interest, and taxes from its revenue. This figure is then divided by the total revenue during that period. To get the percentage, multiply the result by 100.

Operating Profit Margin

A company's operating profit margin or operating profit indicates how much profit it generates under its core operations by accounting for all operating expenses. This type of profit margin takes additional expenses into account, such as interest and expenses.

This metric is calculated by subtracting all COGS, operating expenses, depreciation, and amortization from a company's total revenue. Like the gross and net profit margins, the operating profit margin is expressed as a percentage by multiplying the result by 100.

Example of Gross Profit Margin

Let's assume that Company ABC and Company XYZ both produce widgets with identical characteristics and similar levels of quality.

If Company ABC finds a way to manufacture its product at one-fifth of the cost, it will command a higher gross margin because of its reduced costs of goods sold. This gives Company ABC a competitive edge in the market. But in an effort to make up for its loss in gross margin, XYZ counters by doubling its product price, as a method of bolstering revenue.

There is one downfall with this strategy as it may backfire if customers become deterred by the higher price tag, in which case, XYZ loses both gross margin and market share.

The Bottom Line

As an investor, you'll need to look at some key financial metrics so you can make well-informed decisions about the companies you add to your portfolio. Start by reviewing the gross profit margin of businesses you may find interesting. You can calculate this by subtracting the cost of goods sold from a company's revenue—both are figures you can find on the income statement. The higher the margin, the more profitable and efficient the company. But be sure to compare the margins of companies that are in the same industry as the variables are similar.