Gross Profit Margin Formula & Definition Explained

What is the Gross Profit Margin

Gross profit margin is a financial ratio that measures the percentage profit of the sales after the cost of sales is deducted. The gross profit margin indicates the company’s ability to manage its costs in generating profit. In other words, the gross profit margin shows how much a profit is left after the cost of producing goods and services and paying workers.

The gross profit margin is a comparison between the gross profit and the net sales. Thus, the higher the gross profit margin, the more profit left (or the lower costs). In contrast, the lower the gross profit, the company has less profit due to the costs.

The higher value indicates that the company may achieve production efficiency and vice versa. But the actually good gross profit margin ratio is the stable or growing gross profit margin compared to the industry average or the company’s historical data.

In the same way, the actually bad gross profit margin ratio for the managers and investors is the ratio that shrinking which indicates the company’s ability to manage its costs is unstable.

Gross Profit Margin Formula

The gross profit margin can be calculated by dividing the company’s gross profit (net sales – the cost of goods sold) by the net sales, as the following gross profit margin formula:

GPM = (Net sales – Cost of sales) / Net sales x 100

or

GPM = (Gross Profit / Net sales) x 100

Where:

• Cost of sales or Cost of goods sold (COGS) is the direct cost of producing the goods and services by a company such as raw materials costs, direct labor costs, and other costs related to selling. However, the indirect costs are excluded.
• The gross profit is equal to the net sales – the cost of sales.
• The value is expressed as a percentage.

Don’t worry, these values (gross profit, net sales, and cost of sales) can be taken from the income statement.

Gross Profit Margin Example

The Feriors company limited has a net sales of $100,000 and a cost of sales of $25,000 for the last year.

The gross profit margin will be: GPM = (100,000 – 25,000) / 100,000 x 100 = 75%

The Feriors’ gross profit margin of 75% means the company generates 75% of gross profit from net sales. In other words, the company generates 75 cents for each $1 of net sales while 25 cents is its costs.

How to Increase Gross Profit Margin

As you can see in the gross profit margin formula and the example above, the gross profit margin relies on two factors, the cost of sales and the net sales. Thus, there are two simple methods to increase the company’s gross profit margin:

• Increasing price to generate more sales (increase the net sales).
• Improve the cost efficiency to reduce the costs.

Frequently Asked Questions