Gross Profit Margin, or GPM, is an important financial metric that can be used to assess a company’s financial health, profitability, and efficiency of operations. Below, we are going to cover how to calculate gross profit margin, how to interpret the results, and why the calculation matters for understanding the overall financial position of a company.
Highlights/ Key Takeaways
- Gross Profit Margin is a financial metric that measures a company’s profitability and its ability to operate efficiently.
- The GPM metric can be calculated by subtracting a company’s Cost of Goods Sold from the total product sales, expressed as a percentage of total product sales.
- Gross Profit Margin is often used to compare the financial health of companies operating within the same industry or evaluate the profitability trend of the same company over the years.
- A company’s GPM can be improved by reducing operating expenses or improving the company's productivity and efficiency.
What Is Gross Profit Margin?
Gross Profit Margin, or GPM, is an accounting metric that shows how much revenue a business makes after covering the Cost of Goods Sold (COGS). GPM is expressed as a percentage of sales; it can be calculated by dividing the revenue left after subtracting the COGS by the total revenue.
The higher a company’s Gross Profit Margin, the more revenue is left to cover other expenses like debt repayment and taxes. The remaining revenue can also be used to generate more profit.
To get a full picture of a firm’s financial health, other profitability metrics should be used in conjunction with the GPM calculation. These include:
- EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Higher EBITDA values indicate higher profitability of a company.
- Operating profit. Operating profit represents the total earnings from a company’s main business operations. This metric excludes deductions of tax and interest.
- Net profit. This is the earnings of a business that are left after deducing all operating, tax, and interest expenses over a certain period of time.
- Cash flow. This term describes the net amount of cash or cash equivalents that are transferred in or out of a company.
How to Calculate Gross Profit Margin
Gross Profit Margin can be calculated by subtracting direct expenses from net sales, expressed as a percentage of total net sales:
GPM = (Net Sales - COGS) / Net Sales x 100%
Here, Net Sales represents gross revenue minus allowances, returns, and discounts. COGS stands for “Cost of Goods Sold,” which refers to the direct costs incurred while producing or manufacturing the goods sold by a company.
During the year 2022, Company ABC earned $100,000 in Net Sales, spending $45,000 on the production of the goods. First, the COGS of $45,000 must be subtracted from $100,000, which leaves $55,000. Next, $55,000 must be divided by Net Sales, or $100,000, resulting in a Gross Profit Margin of 0.55 or 55%.
What Does Gross Profit Margin Tell You?
Determining a company’s Gross Profit Margin can be useful for comparison purposes. As such, looking at a company’s GPM values for several reporting periods can provide important insight into whether the company’s operations are becoming more or less efficient. Similarly, calculating GPM for multiple companies within the same industry can help one to understand which companies have the most efficient operations.
In our previous example, we have determined that Company ABC had a Gross Profit Margin of 55% in 2022. Similarly, we can find that its GPM was 46% in 2020, increasing to 48% in 2021, and, finally, to 55% in 2022. The higher Gross Profit Margin, the better. This means that ABC has improved the efficiency of its operations between 2020 and 2022.
Looking at ABC’s competitor company DEF, we determine that DEF’s Gross Profit Margin was equal to 61% in 2023. Thus, we can conclude that Company DEF has more efficient operations as compared to Company ABC.
“Looking at a company’s GPM values for several reporting periods can provide important insight into whether the company’s operations are becoming more or less efficient.”
What is a Good Gross Profit Margin?
In general, the higher Gross Profit Margin - the better. A higher GPM value will always indicate more efficient company operations, but the definition of a “good Gross Profit Margin” can vary significantly from industry to industry.
Benchmarking is a great way of determining the strength of a GPM value. By looking up average gross profits for companies within a specific industry, you will be able to compare how the company in question performs in relation to its competitors. Tacking GPM values over time can also provide valuable insight into the performance trend of a company.
Here are a few examples of the average Gross Profit Margin by industry:
- Advertising: GPM of 29.17%
- Computer services: GPM of 24.23%
- Pharmaceutical drugs: GPM of 67.02%
- General insurance: GPM of 40%
- Restaurant and dining: GPM of 30.07%
We have previously found that Company ABC had a Gross Profit Margin of 55% in 2022. While this is a healthy gross profit margin for industries like general insurance and restaurant business, it would fall below average as compared to other companies in the pharmaceutical drug industry.
“By looking up average gross profits for companies within a specific industry, you will be able to compare how the company in question performs in relation to its competitors.”
What is a Bad Gross Profit Margin?
The definition of a “bad Gross Profit Margin” will vary from industry to industry as well. Generally speaking, a lower Gross Profit Margin can indicate that a company is having difficulties controlling its costs. So, if a company’s GPM falls below the industry average, it may signal that the company is not operating as efficiently as its peers. If the company’s GPM metric continues to fall over time, it could indicate that the company is struggling to keep up with its expenses.
It is not uncommon for companies to have a negative profit margin. However, this value is far from ideal: negative GPM means that the cost of production is more than the company is making in sales.
“Negative GPM means that the cost of production is more than the company is making in sales.”
Why Gross Profit Margin Matters
Gross Profit Margin is an important financial metric used by both internal and external stakeholders. The metric serves as an indicator of a company’s operating efficiency and overall financial health. This information is then used by business owners and investors to make informed financial decisions.
- Business owners must be aware of the financial health of their companies at all times. Evaluating and understanding the GPM metric can help business owners and managers to pinpoint strategies to better control costs and become more efficient going forward.
- Investors also use Gross Profit Margin to evaluate companies’ ability to become profitable. They want to understand whether companies have revenue left over to generate returns for investors. A good GPM also indicates that the company is likely to continue growing and further increase investors’ returns.
Gross Profit Margin vs. Gross Profit
To recap, Gross Profit Margin is a metric that determines how much revenue a company makes after paying the Cost of Goods Sold, as a percentage of total revenue:
GPM = (Net Sales - COGS) / Net Sales x 100%
Gross Profit, on the other hand, equals the sales revenue minus the Cost of Goods Sold:
Gross Profit = Net Sales - COGS
This means that Gross Profit Margin equals to Gross Profit as a percentage of Net Sales:
GPM = Gross Profit / Net Sales x 100%
Going back to our original example, Company ABC earned $100,000 in Net Sales, spending $45,000 on the production of the goods. Therefore:
Gross Profit = $100,000 - $45,000 = $55,000
As calculated previously, GPM = $55,000 / $100,000 x 100% = 0.55.
How Can a Company Improve Its Gross Profit Margin?
While there are several strategies available to companies looking to boost their profits, most of them come down to increasing business efficiency and reducing operating expenses. Below are a few steps business owners can take to improve their Gross Profit Margins:
- Renegotiate better deals. If your business heavily relies on suppliers, you can attempt to renegotiate your deal. For example, you could ask for a discount if you purchase inventory in bulk or work with the supplier exclusively.
- Reevaluate your business offerings. Retail or service businesses can analyze sales charts to determine their most profitable offerings. From there, one could narrow down the business focus to deliver solely the most popular items or services.
- Upsell to existing clients. Both service- and retail-based businesses can increase the average order value by enticing existing clients to purchase even more goods or services. For example, you could use an email system to inform previous customers of new products and promotions.
- Increase productivity. Automating manual processes can reduce the Cost of Goods Sold, thus increasing the overall Gross Profit Margins. Evaluate the existing business systems and look for ways to make them more efficient.
Once a small business has taken steps to improve its GPM, it is important to continue monitoring the metric on a regular basis to ensure that the improvements are sustained over time.
How Much Can Gross Profit Margin Tell You About a Company?
In a nutshell, Gross Profit Margin tells you how much a company has made after paying the direct cost of doing business. These costs include direct production costs, such as labor, materials, and more.
To get a well-rounded picture of a company’s performance, Gross Profit Margin should be considered along with the two other major profitability ratios - Operating Profit Margin and Net Profit Margin. Together, these metrics can provide valuable information on the overall performance and financial health of the company, as well as the direction it is headed in.
For example, you can expect the Cost of Goods Sold to increase proportionally with revenues. However, if the COGS increases faster than revenue does, the company is headed in the wrong direction. In contrast, increased revenues with constant COGS indicate that a company has made improvements to its systems and processes, thus boosting overall business efficiency.
“To get a well-rounded picture of a company’s performance, Gross Profit Margin should be considered along with the two other major profitability ratios - Operating Profit Margin and Net Profit Margin.”
Gross Profit Margin, or GPM, is a key profitability metric that can be used to evaluate a company’s business efficiency. Business owners and investors can use GPM along with other financial metrics and ratios to evaluate the overall financial health of a business and make corresponding business or investment decisions.