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Gross Profit Margin: Definition, Formula and Explanation

Sarmaaya Desk
Sarmaaya Content Team

Key Takeaways

  1. Gross Profit Margin determines the amount of money that is left after products of sale is deducted from the cost of goods sold
  2. It is expressed as a percentage of sales.
  3. An unstable gross profit margin indicates either in adept management or poor quality products or services
  4. A higher gross profit margin indicates that a company’s profits from its sales are greater than than the cost incurred to produce them.

What is Gross Profit Margin?

It is also known as the gross margin ratio. It is used by financial analysts to examine a company’s financial standing and health by determining the amount of money that is left after products of sale is deducted from the cost of goods sold (COGS). Usually, it is expressed as a percentage of sales.

How to calculate it?

All the information and figures required to calculate it are available on a company’s income statement. To calculate it, we first deduct Cost of goods sold from net sales i.e gross revenues minus returns, discounts and allowances. We then divide it by net sales to express our answer into a percentage. The following formula and example will illustrate the calculation:

Gross Profit Margin = (Net Sales – COGS) / Net Sales

For company X, for a given year their net sales were $25,000 and their cost of goods sold was $10,000. Their Gross profit margin would be:

= (25,000-10,000)/25,000

= 15,000/25,000

= 0.6 or 60%.

Understanding

If it’s unstable then it indicates either in adept management or poor quality products or services. However, it is important for analysts to be aware of a company’s operational changes that may have taken place in business practices and policies of a company which will account for the fluctuations and will not present any harm to the company. An example of this could be a company which brought changes in their operations and supply chain function. While this will incur an initial hefty cost, it would be accounted for with the increase in efficiency effectiveness of the overall processes which would ultimately result in a reduction of cost.

If it’s higher then it indicates that a company’s profits from its sales are greater than than the cost incurred to produce them. It indicates greater efficiency in terms of producing output from raw materials. The converse is true for a lower gross profit margin. This shows that a company is not very efficient in producing outputs from its raw material, thereby incurring extra costs and thus, generating lesser profits.

Financial analysts and investors use gross profit margin to assess a company’s profitability against its competitors. The percentage analysis over time will help them understand the company’s overall performance and the potential returns it can deliver. A higher percentage will indicate greater efficiency, therefor greater earning potential for the investors which will catch their interest immediately.

 




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