How to Calculate Gross Profit Margin

The gross profit margin assesses a company's basic process efficiency. It informs managers, investors, and others about the amount of sales income left after deducting the company's cost of goods sold. Any money left over is used to cover selling, general, and administrative costs. Salaries, R&D, and marketing are all examples of this. They appear at the bottom of the revenue statement. If all else is equal, the bigger the gross profit margin, the better.

A Crucial Business Metric

The gross margin is a useful metric within industries and sectors because it allows for a better comparison of apples-to-apples among competitors. A corporation with larger gross profit margins than its competitors nearly always has stronger procedures and operations. These efficiencies may indicate that the company is a safer long-term investment, as long as its valuation multiple isn't too high. Reading studies from research analysts, rating agencies, statistics services, and other financial data suppliers may help you determine the appropriate gross margin range for the industry. Many brokerage firms also provide research tools. Investors with an account with Charles Schwab, one of the leading brokers in the United States, for example, get access to commentary and analysis from organizations such as the Swiss bank Credit Suisse. Clients of the organization may download and study financial reports from a variety of industries, which contain gross profit margin figures. Similar tools are available from other big brokers.

How to Figure Out Gross Profit Margin

Using the following formula, you can calculate a company's gross profit margin: Gross profit margin = total revenue x gross profit The gross profit total may be calculated using a company's income statement by beginning with total sales and deducting the line item "cost of goods sold." This represents the company's profit after covering all manufacturing expenses but before paying any administrative or overhead costs, as well as anything else that does not directly contribute to the manufacture of the company's widgets.

Fictional Company Example

Assume you wish to calculate the gross profit margin of a fictitious company named Greenwich Golf Supply. Table GGS-1 at the bottom of this page contains its revenue statement. Assume that the average golf supply firm has a gross margin of 30% for this experiment. Plug the figures from Greenwich Golf Supply's statement into the gross profit margin formula:

$162,084 gross profit ÷ $405,209 total revenue = 0.40, or 40%

The response of 40% demonstrates that Greenwich outperforms most of its competitors in terms of product manufacturing and delivery. After learning that a company has a higher gross profit margin, a potential investor, analyst, or rival will want to know, "Why?" Why are Greenwich's profits higher? Is it able to obtain low-cost inputs? If so, will they be able to sustain it? Consider the airlines to demonstrate how gross profit margins may not necessarily hold up over time. When oil prices are expected to rise, several airlines hedge their fuel costs. This allows these companies to make far more each flight than regular airlines. Because the hedging contracts expire, the gain is limited. Therefore, the profit boost will not last.

Example With a Real Business

Assume that the majority of jewelry retailers have gross profit margins ranging from 42 to 47 percent. In light of this, how does Tiffany & Co. fare? Examine the firm's 2019 income statement to uncover the solution. Tiffany made a $2,760,000,000 profit on $4,424,000 in sales over the time period in question. 4 When you plug that number into the gross profit margin calculation, you'll find:

$2,761,900,000 ÷ $4,424,000,000 = 0.624
0.624 converted to a percentage becomes 62.4%

When these numbers are compared, Tiffany looks to outperform its competition. Tiffany's gross profit margin implies that she can turn more of each dollar of sales into a dollar of gross profit. These increased incomes allow Tiffany to strengthen the brand, expand, and compete with other companies. When you look closer into the firm's yearly data in its 10-K filing, you can see that this is attributable, at least in part, to its ability to achieve far greater sales per square foot than comparable jewelry stores. In 2019, Tiffany's earned about $3,000 per square foot, while Signet Jewelers (which includes Kay Jewelers, Zales, and Jared) earned less than $2,000 per square foot.

Tracking the Gross Profit Margin

Gross margins are usually pretty consistent over the course of a company's life. Large ups and downs might be an indication of fraud, accounting errors, mismanagement, or a spike in raw material costs. If you check at a company's income statement and notice that its gross margin has typically averaged about 3% to 4%, but that in the most recent year, it has abruptly increased to 25%, it should be taken seriously. There might be a valid cause for the rise, but you'll want to know where, how, and why the money is coming from. Using Tiffany & Co. once more, the gross margin stability over a five-year period is as follows:

2015 gross profit margin = 61.0%
2016 gross profit margin = 62.4%
2017 gross profit margin = 62.6%
2018 gross profit margin = 63.3%
2019 gross profit margin = 62.4%

Frequently Asked Questions (FAQs)

What is gross profit margin vs. net profit margin?

The gross profit margin demonstrates how effectively a firm operates. It is calculated by deducting the cost of producing a commodity from the total income generated. The net profit margin of a corporation is calculated by deducting other operational expenditures from the gross profit margin.

What is a bad gross profit margin?

When the total goes negative, the gross profit margin becomes negative. This signifies that the cost of producing and delivering the goods to the consumer is more than the income generated by the sale of the product.