What is Gross Profit Margin?
Gross profit margin is the percentage of sales revenue that a company is able to convert into gross profit. Companies use gross profit margin to determine how efficiently they generate gross profit from sales of products or services.
If a company has net sales revenue of $100 and gross profit of $36, its gross profit margin is 36%. For every dollar of product sold, the company makes 36 cents in gross profit.
- Gross profit margin is a metric that assesses how efficiently the company generates profit from sales of products or services.
- Gross profit margin can help companies compare performance against industry peers, and also assess their own performance over time.
- Gross profit margin does not provide a complete picture of a company’s profitability because it excludes costs that are not directly related to making and selling its products.
- Gross profit margins tend to vary by industry, due to industry-specific costs and the level of competition.
How to Calculate Gross Profit Margin
To calculate gross profit margin, first calculate gross profit. This is defined as net sales revenue minus cost of sales—the cost of services or cost of goods sold (COGS)—the costs associated with producing the company’s goods and services. This includes raw materials and labor used to produce those goods.
Gross profit is then divided by net sales revenue and the result is multiplied by 100 to obtain the gross profit margin percentage.
Gross Profit Margin Formula
Calculating gross profit margin is pretty straightforward. Here’s the formula:
Gross Profit Margin = ((Sales Revenue – Cost of Sales) / Sales Revenue) X 100%
So let’s say a family-owned manufacturer has $20 million in sales revenue, and its cost of goods sold is $10 million. Using the formula above, that would make its gross profit margin 50%.
Gross Profit Margin Explained
Gross profit margin is a good metric for measuring shows how effective a company is at converting goods, materials and direct labor into profit, because it includes only the variable and fixed costs associated with producing or acquiring products and services. It also provides a measure of profitability that is independent of sales volume: if sales increase by a factor of two and cost of sales increases at the same rate, gross profit margin will remain the same.
For manufacturers, the cost of sales—or cost of goods sold (COGS)—includes costs such as raw materials and hourly wages of workers directly involved in manufacturing products. For retailers, the calculation includes the wholesale cost of the products being sold, as wells as shipping costs and labor costs. For services organizations, it will include labor costs and costs to deliver these services, such as travel costs.
Cost of sales excludes fixed expenses that are not directly related to making and selling specific products and services, including administrative costs, research and development (R&D) costs and employee benefits.
Organizations can also use the gross profit margin formula to assess the margin of individual products or lines of business by performing the same calculation but inputting the revenue and costs specifically related to those products or business units.
What Does Gross Profit Margin Tell You & Why Is It Important?
Gross profit margin is good yardstick for measuring how efficiently companies make money from products and services, because it measures profit as a percentage of sales revenue. It can therefore be used to more easily compare companies with different sales revenues.
Gross profit margin also homes in on sales revenue, eliminating general corporate expenses as well as other costs and income that impact a company’s overall profitability, such as legal settlements or income from interest.
Gross profit margin is sometimes used as an indicator of how well a company is managed. High gross profit margins suggest that management is effective at generating revenue based on the labor and other costs involved in generating its products and services. Big changes in gross profit margin quarter-over-quarter or year-over-year can sometimes indicate poor management. Other problems that could cause fluctuations in gross profit margin include temporary manufacturing issues that result in lower product quality and a higher level of product returns, reducing net sales revenue.
Steadily decreasing profit margins can indicate a highly competitive market and product commoditization, where there is little differentiation between competing goods or services. In contrast, steadily increasing profit margins can indicate the company has fewer competitors and/or is able to differentiate its products and sell them at higher prices. But it can also indicate that a company is overpricing its products, increasing margin at the expense of volume—a 20% increase in margin is of little value if revenue falls by 50%.
When gross profit margin declines steadily over time, the company may need to make adjustments to facilitate growth. For example, it may need to look for ways to sell a greater volume of products to compensate for declining profitability. Or this could be a sign that it should consider changing its business model, improving its manufacturing processes to make products more efficiently or cutting costs in other ways.
What Is a “Good” Gross Profit Margin? Should It Be High or Low?
A company will aim for a high gross profit margin. Besides driving more profit to the bottom line (net income), a high gross profit margin leaves more money to invest in R&D and other activities that support long-term growth.
The definition of a “good” gross profit margin depends on the industry in which a company operates. One academic estimates the average across all industries at around 36%. But there’s wide variation, with the average gross profit about 11% for farming and agriculture, 23% for the trucking business and 56% for the semiconductor industry.
A startup or relatively new business may have a lower gross profit margin than more established industry peers because it may offer major discounts to gain market share and can’t yet take advantage of the economies of scale larger companies enjoy.
Advantages and Disadvantages of Using Gross Profit Margin
Gross profit margin is a useful metric for several purposes:
- It’s a quick method for showing the margin on the company’s products and lines of business. It can also serve as a barometer of a business’s management or sales organization.
- It provides a benchmark for comparing a company’s performance with competitors.
- It can highlight areas with opportunity for improvement—for example, if one product or service has higher gross profit margins than others, that could point to an opportunity to reduce COGS or shift the sales strategy for other product lines.
- It can be used to help set pricing at a competitive level while ensuring products are still profitable.
However, gross profit margin does have some limitations:
- It doesn’t show a company’s overall profitability because it doesn’t include all costs.
- Without proper context, it may present an inaccurate view of profitability. For example, a company may need to pay more for raw materials temporarily if several suppliers in a certain region close after a flood, or it may discount heavily in order to capture market share.
- It is less valuable for comparing companies across different industries. Average gross profit margin varies by industry sector, largely because of differences in COGS.
Gross Profit vs. Net Profit Margin
While gross profit margin is a useful financial metric, net profit margin is the true measure of a company’s overall profitability.
Net profit margin differs from gross profit margin in that it includes all the company’s expenses and costs, while the latter only includes COGS. To determine net profit margin, the first step is to calculate the company’s net income (net profit) by subtracting from revenue not only COGS, but all other operating expenses, such as insurance and taxes. Net profit margin is expressed as a percentage; it is calculated by dividing net income by revenue and then multiplying the result by 100.
Gross Profit vs. Gross Profit Margin
Gross profit margin differs from gross profit in that it measures the efficiency with which a company generates revenue as a percentage. Gross profit, on the other hand, is expressed in dollars. A company determines its gross profit margin by dividing gross profit by net sales.
Gross Profit Margin Examples
If a manufacturer has net sales of $230,000 and COGS of $180,000, then its gross profit is $50,000 ($230,000 minus $180,000). Dividing that gross profit of $50,000 by net sales of $230,000 generates a gross profit margin of 22%.
Here are two real-life examples:
3M reported net sales of $32.136 billion and cost of sales of $17.136 million for the year that ended December 31, 2019. Its gross profit was $15 billion ($32.136 billion – $17.136 billion), which puts its gross profit margin at 46.7% ($15 billion/$32.136 billion).
Apple reported annual net sales of $260.174 billion for the fiscal year ending September 30, 2019. Total cost of sales for that period was $161.782 billion. Gross profit, calculated as net sales minus cost of sales, was $98.392 billion, for a gross profit margin of 37.8%.