What is Gross Profit Margin?

Gross profit margin is like leftover pizza...

Although the delivery guy gives you a whole pie, all your dinner guests will take a slice. Once everyone has finished eating, the portion leftover is what you get to keep for tomorrow. If you put 3 out of 8 slices in the fridge, your leftovers (gross profit margin) is 37.5% (3 pieces / 8 pieces).

Imagine two companies in competition. They are both trying to attract customers into their store. One company slashes prices; the other beats them to it.

The customer ends up winning in a price war; buying something he/she wanted for less than what they would have otherwise paid. But the company that wins the sale battle, loses some of the profit they would have received without that competition.

The battle is over when one company puts the price below what it costs the competitor to make it. If company A can produce it for a direct cost of $5, and company B can make it for $4, then company B wins when it drops the price to $4.99 (making a $0.99 gross profit on the widget — 20% gross profit margin).

$4.99 sales price - $4 direct cost = $0.99 gross profit / $4.99 sales price = 20% Gross Profit Margin

The gross profit margin sheds some light on who would win a price war. That’s because the company with the highest gross profit margin has the lowest direct cost of production, assuming they are charging the same price.

Therefore, Company B has the most wiggle room in their pricing. A higher gross margin typically indicates that a company is more efficiently run and more financially stable (in operations) than others in the same business.

Typically, the gross profit margin of a business is a measure of its efficiency. It indicates how well a company is utilizing its raw materials and direct labor.

That’s a competitive advantage that allows a business to maintain higher gross profit margins or offer a lower price to capture more market share. As such, the company is more valuable than its competition.

To calculate a company’s gross profit margin, you need to know its net sales and its cost of goods sold (COGS) for the duration in consideration.

COGS are the direct costs of doing business. If you are making cookies, for example, it’s the cost of the sugar, flour, chocolate chips, etc. Plus, the baker’s salary. It does not include the cost of napkins or the salary of the manager. Because these things don’t fluctuate with the number of cookies being baked, they are considered fixed costs, indirect costs, or overhead.

“Net sales” is the number that focuses on the final revenues from a business operation. It is calculated by deducting refunds, reimbursements, and other non-business unit revenues from gross sales. It is this statistic that can allow us to calculate gross profit margin on a product or service. Sometimes an income statement only shows “total revenue.” Here is the formula:

(Net Sales - Costs of Goods Sold) / Net Sales

The result is the gross profit margin. However, it is most often described as a percentage. That’s easy to get. Just round the number to two places after the decimal. Then, erase the decimal point and tag a percentage sign to the end. There you go.

There are a lot of ways to slice up the numbers from a company’s financial statements. As a result, there are a lot of different metrics out there. Gross profit margin is just one of them.

You’ll notice that while calculating gross profit margin, the cost of goods sold (COGS) (different from total costs) is subtracted from net sales. That’s because gross profit margin is meant to measure the efficiency of the business operations. The goal is to understand how much out of every unit goes toward the production of that unit, and how much it contributes to the company’s profit.

Net Sales - COGS = Gross Profit

But, a business operation will usually have more costs than just those directly involved in producing goods or delivering a service. Like, the cost of advertising, paying rent, and other expenditures. These are considered indirect costs. They are an important part of doing business, but they don’t change a lot when the business produces an extra unit.

Gross Profit - Indirect Costs = EBITDA

Subtracting indirect costs from revenue generates “earnings before interest, taxes, depreciation, and amortization” (aka EBITDA).

But to understand how much of a company’s total revenue ultimately stayed in the owners' pockets, you’ll need to include all of those additional deductions and taxes.

When you do that the result is called “net profit” (aka “net income” or “net earnings”). That number is found at the end of every income statement and is often known as the “bottom line.”

EBITDA - Interest - Taxes - Depreciation - Amortization = Net Profit

Gross profit margin is the percentage of revenue that remains after subtracting the direct costs of doing business. It shows you how efficient a company is at producing the things it makes.

Net Sales - COGS = Gross Profit / Net Sales = Gross Profit Margin

Conversely, net profit margin is the percentage of revenue that remains after paying for all business costs. It tells you the percentage of all of the company's revenues that end up going to the owners.

(Net Sales - COGS - Indirect Cost - Interest - Taxes - Depreciation - Amortization) / Net Sales = Net Profit Margin

Here’s the deal. You can’t only rely on gross profit margin to decide which company is in good financial health. For one, some industries are far more competitive than others.

Companies that use a lot of raw materials (like, car manufacturers) are going to have lower gross margins than companies that don’t (like, software companies).

Below we list gross profit margins for some businesses from the second quarter of 2019. You can clearly see the difference between the industries.

2Q19 Gross Profit Margins:

Remember, competition may drive down gross profit margins. So, comparing the gross profit margin of an antique dealer to a bubble gum manufacturer isn’t going to tell you much.

Plus, a low gross profit margin doesn’t necessarily mean a company isn’t well-managed. Nor does it mean that the company isn’t making a profit. But, the lower gross profit margin , the higher the sales volume needs to be (at $1 per unit, it takes a million units to reach a million dollars in profits; at $1,000 per unit, it only takes 1,000 units). If a company is running a much lower gross profit margin than its competitors without a substantially larger market share, it may not be a good sign. That probably means that either they are spending more resources on the same product or that they have a less reputable brand.

Similarly, a high gross profit margin isn’t necessarily optimal. If a business does not have patent protection, it might be hard to maintain the associated revenues when competitors are attracted to the market. Plus, a high gross profit margin may indicate that a product is overpriced, and potential customers are turning around at the sales counter. In some cases, reducing the gross profit margin can actually increase a company's sales and total profits.

The answer to what is a “good” gross profit margin (GPM) is the dreaded “it depends.” The best way to figure out if a company has a good gross profit margin is to look at the average GPM of the companies conducting the same business. A good gross margin is above that average. Some competitive industries have “good” gross margins as low as 10%. For others, anything less than 50% is bad.