Buzz
The gross profit margin is a straightforward comparison between the cost of goods your company sells and the income generated from those products. Gross margin is the percentage of gross profit relative to total revenue. It serves as a quick and useful way to compare your business to competitors or the industry average. It is also employed to evaluate your company's current performance compared to past results, especially in a market where the value of your goods may fluctuate significantly.
Steps
Calculate the gross profit margin
Find Net Revenue and Cost of Goods Sold. The company’s income statement will display these two values.
Gross Profit Margin = (Net Revenue – Cost of Goods Sold) ÷ Net Revenue.
Example.Understanding the concept
Understanding Gross Profit Margin. The Gross Profit Margin (GPM) represents the percentage of revenue that remains after a company covers the cost of producing its goods. All other expenses (including shareholder dividends) must be accounted for using this percentage. This makes the GPM a strong indicator of profitability.
Determine Net Revenue. A company's net revenue is the total revenue minus profit, allowances for damaged goods, and discounts. This method provides a more accurate calculation of the actual income compared to just using total revenue.
Calculate the Cost of Goods Sold. Abbreviated as (COGS), this figure includes the costs of materials, labor, and other expenses directly related to the production of goods or services. It does not include distribution costs, labor not related to the production process, or other indirect expenses.
Avoid confusion between Gross Profit and Gross Profit Margin. Gross Profit is calculated by subtracting Cost of Goods Sold from Net Revenue. It is represented in monetary units or another form of currency. The above formula converts Gross Profit into Gross Profit Margin, expressed as a percentage, allowing for easier comparison with other companies.
Understand why these numbers are critical. Investors refer to the Gross Profit Margin to gauge how efficiently a company utilizes its resources. If one company has a Gross Profit Margin of 10% and another has 20%, the second company is earning more money per dollar spent on goods. Assuming all other costs between the two companies are fairly similar, the second company would be the better investment opportunity.
- It’s best to compare companies within the same industry. Some types of goods and services have lower average profit margins than others.
