The gross profit margin ratio, also known as gross margin, is the ratio of gross margin expressed as a percentage of sales. Gross margin, alone, indicates how much profit a company makes after paying off its Cost of Goods Sold. It is a measure of the efficiency of a company using its raw materials and labor during the production process. The value of gross profit margin varies from company and industry. The higher the profit margin, the more efficient a company is. This can be assigned to single products or an entire company.
NOTE: Want the Pricing for Profit Inspection Guide? It walks you through a step-by-step process to maximizing your profits on each sale. Get it here!
Joe is a plumber in Houston, Texas. He has recently started his company and has a lot to learn. Joe thinks he may be able to cut back on raw materials by changing his construction process. Essentially, he is wondering what is his gross profit margin rate is. He evaluates his company financials for relevant information. Once the proper numbers are found uses the gross profit margin ratio calculator on his Texas Instruments BA II. His results are shown below.
Calculate the gross profit margin ratio using the following formula:
Gross profit = revenue – cost of goods sold
Use the following formula to calculate the percentage of sales:
Gross profit margin ratio = (15,000 -10,000) / 15,000 = 33%
The gross profit margin ratio analysis is an indicator of a company’s financial health. It tells investors how much gross profit every dollar of revenue a company is earning. Compared with industry average, a lower margin could indicate a company is under-pricing. A higher gross profit margin indicates that a company can make a reasonable profit on sales, as long as it keeps overhead costs in control. Investors tend to pay more for a company with higher gross profit.
Many see gross profit margin disadvantages despite the common use of gross profit margin ratios. The issue is that certain production costs are not entirely variable. Some believe that only direct materials should be included as they are the only variable to change in proportion to revenue. When applied, this new gross profit margin causes the transference of all other related costs to operational and administrative cost categories. This tends to cause a higher gross margin percentage than originally. Certain industries and businesses apply it instead of the more common application. Use the following formula:
Gross Profit Margin = (Revenue – Direct Materials) / Revenue
Easily discover if your company has a pricing problem. As you analyze your gross profit margin, it’s an opportune time to take a look at you pricing. Download the free Pricing for Profit Inspection Guide to learn how to price profitably.
[box]Strategic CFO Lab Member Extra
Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.
Click here to access your Execution Plan. Not a Lab Member?
Click here to learn more about SCFO Labs[/box]