Gross Profit Margin: How to Calculate Gross Profit Margin

Gross profit margin—also called gross margin, gross margin percentage, or gross profit percentage—is the percentage of a company's revenue that's greater than its cost of goods sold (COGS). This financial ratio demonstrates how effectively a business generates revenue compared to managing their production costs.

A company's gross profit margin takes into account variable costs, which are expenses that change based on production volumes, such as sales commissions, direct materials, direct labor, shipping fees, credit card fees on sales, and product packaging. The gross profit margin metric does not factor in fixed costs, which include items like administrative costs, rent, depreciation, amortization, and insurance. Since it doesn't take into account all expenses, gross profit margin is not an accurate indication of a company's overall financial health.

Businesses generally aim to have the highest gross profit margin possible without charging a price that significantly decreases sales volume. A high gross profit margin benefits a business in several ways:

1. 1. Helps surpass the break-even point: A goal for new businesses is to simply break even and become profitable. The higher a company's gross profit margin, the faster it can earn enough revenue to break even and begin operating at a profit.
2. 2. Increases cash flow: A higher gross profit margin indicates that a company is profiting more from product sales and has more cash flow to pay for indirect operating costs, hire additional labor, pay debt, or invest in growth for the future.
3. 3. Attracts investors: Small gross profit margins leave less room mishaps or unexpected occurrences, which could put the company in the red. Larger gross profit margins minimize the risk for investors because there's room for a company to make errors and still remain profitable.
4. 4. Helps determine pricing: The gross profit margin is a useful figure when determining the optimal sales price for a product or service. A business owner can set a target gross profit margin based on the industry standard gross profit margin, and then work backward to figure out the best sales price to hit that margin based on the cost of goods sold (COGS).

In order to calculate gross profit margin, you must understand the meaning of cost of goods sold (COGS). COGs, also called cost of sales, is a company's direct cost of producing goods sold to a distributor, retailer, or manufacturer during a given period. This cost is deducted from revenue or sales to determine a company's gross profit and gross margin. From an accounting perspective, COGS is considered a business expense and is usually listed under sales or income on a company's income statement (or profit and loss statement), which reports income for an accounting period.

Figures that are a part of COGS include the cost of items intended for resale, direct labor costs, cost of raw materials, supplies used for manufacturing or sales of a product, and shipping, container, and freight costs. Other factors, like indirect costs (or indirect expenses), distribution and sales force costs, and overhead costs, may not be considered part of the cost of goods, depending on the source. Additional factors such as operating expenses, like rent, utilities, and marketing costs, may also vary by basis.

To calculate the gross profit margin ratio, subtract the cost of goods sold (COGS) from total sales revenue and divide that figure by the total sales revenue, as seen in the following gross profit margin formula:

Revenue represents the total amount of money earned from product sales, and COGS represents the product production costs that fluctuate based on the amount of output.

In the gross profit margin calculation, some companies may substitute net sales in place of total revenue. Net sales is similar to total revenue, except it deducts the price of refunded or returned sales, allowances, and discounts.

Gross profit margin and gross profit both measure a company's profitability using its revenue and cost of goods sold (COGS), but there is one key difference. Gross profit is a fixed dollar amount, while gross profit margin is a ratio. The fact that gross profit margin is a percentage makes it a useful metric for business owners to compare their margin against the industry standard or competitors. For instance, if you launch a new small business, it wouldn't make sense for you to compare your gross profits with a large established competitor making millions of dollars more in revenue. Instead, you could compare your gross profit margins because both gross profit margin percentages are expressed in proportion to the size of each company's revenue and COGS.

There are different financial metrics you can use to track your company's health and compose your company's financial statements:

1. 1. Gross profit: Gross profit is the amount of income left over after subtracting the cost of goods sold (COGS) from the total sales revenue. This metric indicates whether a company’s production process needs to be more or less cost-effective in comparison to its revenue.
2. 2. Gross profit margin: This profitability ratio is the percentage of revenue generated that's greater than the COGS. To calculate gross profit margin, divide gross income by revenue and multiply the result by 100.
3. 3. Net profit: Calculate the net income metric by subtracting total expenses from total revenue to see exactly how much a company profits (a new profit) or loses (a net loss). A company's net income over time is a great indicator of how well or poorly its management team runs the company. Net income is also called net profit, net earnings, or bottom line.
4. 4. Net profit margin: Net profit margin is the ratio of net profit to total revenue expressed as a percentage. To calculate net profit margin, divide your net income by total revenue and multiply the answer by 100.
5. 5. Operating profit: To calculate operating profit or earnings before interest and taxes (EBIT), subtract operating expenses—which include overhead costs like rent, marketing, insurance, corporate salaries, and equipment—from gross profit. Investors find EBIT useful in determining a company's financial performance because it doesn't factor in items that are out of the management team's control.

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