Gross Profit Margin Ratio Definition
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. Gross profit margin can be assigned to single products or an entire company.
Gross Profit Margin Ratio Formula
Gross profit margin = Gross profit ÷ Total revenue
Or = (Revenue – cost of goods sold) ÷ Total revenue
Gross Profit Margin Ratio Example
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.
Gross Profit Margin Ratio Calculation
The gross profit margin ratio would be calculated using:
Gross profit = revenue – cost of goods sold
Example: A company has $15,000 in sales and $10,000 in cost of goods sold.
It would be expressed as a percentage of sales by:
Gross profit margin ratio = (15,000 -10,000) / 15,000 = 33%
This means for every dollar generated in sales, the company has 33 cents left over to cover basic operating costs and profit.
Gross Profit Margin Ratio Analysis
The gross profit margin ratio 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.
Gross Profit Margin Disadvantages
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 all other related costs to be transferred to operational and administrative cost categories. This tends to cause a higher gross margin percentage than originally. It is applied by certain industries and businesses instead of the more common application. This formula is:
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.
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