Gross profit margin, which you may commonly hear referred to simply as “gross margin”, is an important financial metric that helps to evaluate the efficiency of a business's operations.
More specifically, gross margin looks at a company’s sales performance in relation to the efficiency of its production processes (see also: gross profit).
Gross profit margin is an important metric for managers and investors alike, and for a multitude of reasons. Because it's based on the cost of goods sold by a company, the most obvious (and perhaps most important) reason gross profit margin analysis is useful, is that it gives valuable insights into the efficiency with which a company can produce and sell products before extraneous costs are deducted.
Gross profit margin is most often compared alongside operating profit margin and net profit margin to arrive at a comprehensive understanding of an organization’s financial health.
To recap, gross profit margin is most generally used to assess the efficiency of production processes for a product/products sold by a company.
Because businesses are often more efficient at producing and selling some products as opposed to others, managers and shareholders understandably want to have insight into gross profit margins for individual products or lines of business. That being said, it's not always possible to identify the direct costs of producing each product, as there is virtually always some overlap in production expenditures.
Gross profit margin takes into consideration, as we mentioned, the direct costs of producing a given product/product line as will be shown on a company’s income statement.
Direct costs, which are usually variable, are the only things that comprise the cost of goods sold (so, this doesn’t include indirect costs). “Variable” is especially relevant, in this context of understanding efficiency, because variable costs change depending on product production volume.
Similar to many other financial ratios, gross profit margin should be analyzed comparatively. The figure is most useful when taken in the context of a historical trend within an organization, industry, or competitive landscape.
Okay, so now that we’ve got that covered…
The formula to calculate gross profit margin is as follows:
Gross Profit Margin = (Net Sales - Cost of Goods Sold) / Net Sales
The resulting percentage from this formula is your gross profit margin.
It’s worth noting that net sales, as opposed to total revenue, is used in this calculation. That means we arrive at the gross profit margin percentage after subtracting things like returns, discounts, and allowances. As far as cost of goods sold (COGS) is concerned, it's important to again note that:
It’s time to draw some conclusions!
Interpreting your gross profit margin ratio can provide a number of helpful insights, helping you to uncover things like:
Tracking and optimizing key financial management metrics is one of the most important factors behind driving consistent improvements (and growth), especially in the modern context.
Yet while the importance of data and analytics is widely accepted, today's finance teams often aren't getting the value they expect from their investments in analytics.
That's largely because, in our attempt to make analytics fast, powerful, all-seeing, and all-knowing, we've also made them incredibly hard to use. So complex that only experts can make something of their data.
It's vital, therefore, that analytics are made easier for business people (and finance teams). That's what we call Guided Analytics: analytics that assist users in understanding data and using that data to collaborate and drive results.
Some of the things to look for when considering guided analytics for your finance function?