What Is the Meaning of Gross Profit Margin?

Gross profit margin is the markup on goods sold.

Gross profit margin, in layman’s terms, is the relationship between costs, sales volume and prices. It is the difference between the revenue (from net sales) and the total cost of goods sold. Gross profit margin shows the link between the price of an item, number of units sold and the cost incurred in producing each unit of item. According to Linda Pinson in the book “Anatomy of a Business Plan,” gross profit margin is the percentage of every sales dollar remaining after goods have been paid for by a business. It is the markup on the goods sold.

Basics

Gross profit margin is a profitability ratio, with its value expressed in percentage. It indicates how profitable a company has been in the sales it has made. Gross profit margin is the difference between the cost of providing a service, or of producing a product, and the price it is sold for. Gross profit margin varies across different industries. A service sector company, for example, an airlines, typically reports a lower gross profit margin than a software company.

Calculation

Gross profit margin is calculated by dividing the gross profit by net sales.

Gross profit margin = Gross profit / sales by 100.

High Gross Profit Margin

A high ratio of gross profit, or high gross profit margin, is when the cost of an item (including the purchase cost of its raw materials, manufacturing costs and other related costs) is less than the profit derived from it. High gross profit margin is a sign of healthy profitability, and it implies the effectiveness of processes that convert raw materials into finished goods. It can also indicate overpricing, especially if profits are weak and the business is slow.

Low Gross Profit Margin

Low gross profit margin is a warning sign. Factors that contribute to it may include exceptionally high cost of production (due to high cost of acquisition of raw materials, inefficient manufacturing processes and increased wastage) and low selling price (due to low demand, poor quality and greater competition. Other potential culprits that contribute to a low gross profit margin include high levels of debt and high overheads.

Importance

The gross profit margin indicates the production efficiency of a business. It is used by managers and compared with the gross profit margin values of other, more successful businesses in the same industry.

The gross profit margin reflects the competitive strengths and financial health of a company. It reflects a company's raw material acquisition, product production and distribution efficiency during its manufacturing process.

Gross profit margin denotes the profits made by the company after the cost of goods sold is subtracted from it. Companies that report higher gross profit margins than others are more attractive to investors than those whose gross profit margins are average or below average.

References

• “Finance”; Angelico A. Groppelli and Ehsan Nikbakht; 2006
• “Basic Financial Management”; Pramod Kumar Jain and M. Y. Khan; 2005
• “EDGAR: An Investor's Guide to Making Better Investments”; Gene Walden; 2003
• “Anatomy of a Business Plan”; Linda Pinson; 2008
• “Cornerstone of Financial Accounting”; Jay S. Rich and Jefferson P. Jones; 2009