Gross profit margin

Checked for updates, April 2022. Accountingverse.com

What is Gross Profit Margin?

The gross profit margin (also known as gross profit rate, or gross profit ratio) is a profitability metric that shows the percentage of gross profit of total sales.

Gross Profit Margin Formula

Gross profit margin is calculated using the following basic formula:

Gross profit ÷ Sales

Gross profit is equal to sales minus cost of sales.

If there are sales returns and allowances, and sales discounts, make sure that they are removed from sales so as not to inflate the gross profit margin. A more accurate formula is:

Gross profit ÷ Net sales

where: Net sales =
Gross sales – Sales Returns and Allowances – Sales Discounts

Also, the gross profit margin can be computed as 1 − Cost of sales ratio.

Example

The gross profit margin uses the top part of an income statement.

 Year 2 Year 1 Gross sales 1,500,000 960,000 Less: Sales discounts 12,000 9,000 Sales returns and allowances 20,000 15,000 Net sales 1,468,000 936,000 Less: Cost of sales 1,158,000 671,000 Gross profit 310,000 265,000

The gross profit margin for Year 1 and Year 2 are computed as follows:

Gross profit margin (Y1) = 265,000 / 936,000 = 28.3%

Gross profit margin (Y2) = 310,000 / 1,468,000 = 21.1%

Notice that in terms of dollar amount, gross profit is higher in Year 2. Nonetheless, the gross profit margin deteriorated in Year 2. The cost of sales in Year 2 represents 78.9% of sales (1 minus gross profit margin, or 328/1,168); while in Year 1, cost of sales represents 71.7%.

In terms of managing cost of sales and generating gross profit, the company did better in Year 1 than in Year 2.

Interpreting the Gross Profit Margin

Generally, the higher the gross profit margin the better. A high gross profit margin means that the company did well in managing its cost of sales. It also shows that the company has more to cover for operating, financing, and other costs. The gross profit margin may be improved by increasing sales price or decreasing cost of sales. However, such measures may have negative effects such as decrease in sales volume due to increased prices, or lower product quality as a result of cutting costs. Nonetheless, the gross profit margin should be relatively stable except when there is significant change to the company’s business model.

Key Takeaways

Gross profit margin

• a measure of a company's profitability, computed as: gross profit divided by total sales
• gross profit is equal to total sales minus cost of sales
• the higher the GP margin, the better; a high ratio means that the company makes huge gross profits to soak up operating and other expenses to come up with a net income.
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