Gross Profit Margin: Formula and What It Tells You

What Is Gross Profit Margin?

Gross profit margin is a financial metric analysts use to assess a company’s financial health. It is the profit remaining after subtracting the cost of goods sold (COGS).

In simple terms, gross profit margin shows the money a company makes after accounting for its business costs. This metric is usually expressed as a percentage of sales, also known as the gross margin ratio. A typical profit margin falls between 5% and 10%, but it varies widely by industry.

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​​

First, subtract the COGS from a company’s net sales, which is its gross revenues minus returns, allowances, and discounts. Then, divide this figure by net sales to calculate the gross profit margin as a percentage.

How Gross Profit Margin Works

Gross profit is a company's total profit after deducting the cost of doing business, specifically its COGS, and is expressed as a dollar value. Gross profit margin, on the other hand, is this profit expressed as a percentage. 

Gross profit margin is one of the key metrics that analysts and investors use to assess a company's financial health and efficiency. Companies use gross profit margin to identify areas for cost-cutting and sales improvement. A high gross profit margin indicates efficient operations, while a low margin suggests areas needing improvement. 

Product pricing adjustments may influence gross profit margins. Typically, selling products at a premium increases gross margins. However, high prices may reduce market share if fewer customers buy the product. This can be a delicate balancing act, requiring careful management to avoid losing customers while maintaining profitability.

Fluctuating margins might also indicate poor management or product issues, but they can also reflect justified operational changes, such as initial high costs for automation that eventually reduce overall expenses.

Any temporary volatility shouldn’t be a concern. For example, while the initial investment in automating supply chain formations may be high, the cost of goods will eventually decrease due to reduced 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 indicating a company's financial health. Also known as net margin, it shows the profit generated as a percentage of the company's revenue. Simply put, net profit margin is the ratio of its net profit to its revenues.

Management can use the net profit margin to identify business inefficiencies and evaluate the effectiveness of its current business model.

To calculate a company’s net profit margin, subtract the COGS, operating expenses, other expenses, interest, and taxes from its revenue. Then, divide this figure by the total revenue for the period and multiply by 100 to get the percentage.

Operating Profit Margin

A company’s operating profit margin or operating profit indicates how much profit it generates from its core operations after accounting for all operating expenses.

To calculate operating profit margin, subtract the cost of goods sold (COGS), operating expenses, depreciation, and amortization from total revenue. You then express the result as a percentage by dividing by total revenue and multiplying by 100, similar to gross and net profit margins.

Example of Gross Profit Margin

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

If Company ABC finds a way to manufacture its product at one-fifth of the cost, it will command a higher gross margin due to its reduced cost of goods sold. This gives Company ABC a competitive edge in the market. To compensate for its lower gross margin, Company XYZ decides to double its product price to boost revenue.

However, this strategy by Company XYZ has a potential downside: it might backfire if customers are put off by the higher price. In that case, Company XYZ could lose both gross margin and market share.

The Bottom Line

As an investor, it's smart to look at key financial metrics to make well-informed decisions about the companies you add to your portfolio. One important metric is the gross profit margin, which you can calculate by subtracting the cost of goods sold from a company’s revenue. Both figures are available on the income statement.

A higher gross profit margin indicates a more profitable and efficient company. However, comparing companies' margins within the same industry is essential, as this allows for a fair assessment due to similar operational variables.