Gross profit margin

Published: Jan 2010

Gross profit margin, sometimes referred to as ‘mark-up’ or ‘margin’, is the percentage profit made from revenue less the cost of goods sold. Gross profit margin is a good measure of financial health, since it is essentially the source of funding for other expenses, such as distribution and sales costs.

Gross profit margin may be used as a tool for comparing a company’s performance with its peers. The company with the greatest gross profit margin would be deemed the most efficient. Alternatively it could indicate that the company is overcharging for its products; this could present an issue if a competitor were to enter the market offering lower prices.

How is it calculated?

Gross profit margin is quoted as a percentage of total revenue:

$$\mathrm{Gross \: profit \: margin} = \frac{Revenue \: – \: COGS}{Revenue}\: \times 100$$
• (Revenue – COGS).

This is the same as gross profit.

• COGS.

This is the cost of producing the goods sold.

Company A’s gross profit margin for 2008 is:

$$\frac{530,119 \: – \: 307,898}{530,119}\:\times 100 = 42\%$$

Its gross profit margin for 2009 is:

$$\frac{375,023 \:-\:216,400}{375,023} \:\times 100 = 42\%$$

Although the gross profit margin is the same for both years, 2009 earnings are much lower than those for 2008. This demonstrates the importance of using gross profit margin in conjunction with other financial metrics.

Points to consider

In general a company’s gross profit margin would be expected to remain fairly stable from one year to the next. Any major fluctuations in gross profit margin may be attributable to fraudulent activity or accounting irregularities, thus making it advisable to monitor gross profit margin closely. A gradual decline in gross profit margin may indicate a drop in efficiency or that selling prices are under pressure.

It is also important to monitor gross profit margin in the context of market conditions. If the cost of raw materials increases, for example, and the company does nothing to account for these rising costs, this will have a negative impact on gross profit margin. Equally, in the wake of the financial crisis, companies have generally responded by lowering prices in order to boost sales. This will also be manifested in a drop in gross profit margin. Consequently, gross profit margin can also be used as an indication of a company’s ability to adapt to a changing economic environment.