Understanding Gross Profit Margin (Formula & Definition)

The Gross Profit Margin is the amount left after paying all the expenses related to manufacturing and delivering the product or service.

The formula of Gross Margin:

Gross Margin = Total Revenue – Cost of goods sold

                                          Total Revenue

To calculate the percentage, multiply the total amount of gross margin by 100.

gross profit margin

Here’s What we’ll cover:

What is Gross Margin?

Gross Margin is the value that shows how efficient a business is and how it is performing in terms of generating sales. Gross margin is also known as Gross Profit margin. 

Gross margin is a valuable financial instrument that helps the company’s managers and investors know about the company’s financial health, how much profit has been gained, and the impact of pricing on product sales. The gross margin is also compared with the net profit margin and operating profit margin. 

How to calculate Gross Margin in Dollars?

The formula to calculate gross margin dollars is as follows:

Gross Margin = Revenue – Cost of goods sold

The formula for calculating the percentage of Gross Margin:

Gross Margin = Total Revenue – Cost of goods sold x 100

                                          Total Revenue

We take an example of ABC Company that produces pants. The business of ABC Company has been operational for the year as it was not operational back then. The company now wants to know how efficiently it performs and what changes need to be made in terms of costs, prices, etc. The company will have to start calculating to account for its operations.

The total sales following revenue for the year were $900,000.

The Cost of goods sold includes direct material, labor, and factory overhead cost. The Cost of goods sold for the year was $700,000. 

Calculation of gross margin in dollars:

Gross Margin = $900,000 – $700,000

                      = $200,000

The ABC company has generated gross margin of $200,000.

The company also wants to know about its progress in the form of a percentage. 

Calculation in percentage:

Gross Margin = $900,000 – $700,000 x 100

                                $900,000

                      = 22.2%

The ABC Company’s pants’ gross margin is 22.2%.

How do I calculate markup from margin?

  • Turn your margin into a decimal by dividing the percentage by 100.
  • Subtract this decimal from 1.
  • Divide 1 by the product of the subtraction.
  • Subtract 1 from the product of the previous step.

You now have markup expressed in the decimal form!

If you want to have markup in percentage form, multiply the decimal by 100.

What is a good Gross Profit Margin?

To explain a good gross profit margin, we consider the example discussed above for the ABC Company. Is 22.2% gross margin a good one? 

To answer this question, we have two considerations:

Gross Profit Margins are specific to an industry:

A good gross profit margin varies from industry to industry. According to the Los Angeles retail clothing profit margin ranges from 8-18%.

The ABC Company is performing very well, having a gross profit of 22.2% that exceeds its industrial range. The price highly influences the gross margin in every aspect.

Gross Profit Margins can be lower for a startup company:

Whenever a business starts, it usually faces problems where gross profit can be low because of new operations, costs, etc. A new business takes time to start generating profits.

Should Gross Profit Margin Be High or Low?

Gross profit margin should be high, as a higher margin means that there is more available to invest, save, and/or cover indirect expenses. A high gross profit margin indicates that a company is making more profit on sales and is, therefore, more efficient at converting raw materials into income. A low-profit margin usually means that a company is less efficient at converting raw materials into income and is making less profit from its sales.

Many investors and analysts use gross profit margin to gauge a company’s profitability in order to compare it with competitors. The percentage is also used to track a company’s progress over time. Since a higher margin can indicate increased efficiency and greater earning potential, investors may be willing to pay more for companies with higher profit margins.

Why should you calculate the operating margin?

Gross margin helps in figuring out the progress of a business with its direct costs. But we cannot miss the indirect costs, such as administrative and personnel costs, included in the operating margin.

The indirect cost plays a significant role sometimes in case of loss in a business. That’s why businesses think of reducing indirect expenses first, which would not impact its vital operations. 

What Is the Difference Between Gross Profit Margin and Net Profit Margin?

Profit margin is a percentage measurement of profit that expresses the amount a company earns per dollar of sales. If a company makes more money per sale, it has a higher profit margin.

Gross profit margin net profit margin, on the other hand, are two separate profitability ratios used to assess a company’s financial stability and overall health.

Are margin and profit the same?

Although both measure the performance of a business, margin, and profit are not the same. All margin metrics are given in percent values and therefore deal with relative change, good for comparing things that are operating on a completely different scale. Profit is explicitly in currency terms, and so provides a more absolute context – good for comparing day-to-day operations.

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