What is gross profit margin and how is it calculated?

Revolut Contributor

 · June 21, 2020  · 06/21/2020

Gross profit margin is a ratio that reveals how much profit a business makes for every pound it generates in sales before it accounts for indirect costs. In simple terms, indirect costs are the day-to-day running costs that relate directly to achieving these sales, such as raw materials and the wages of staff directly involved in making the products or services.

What is the gross profit margin formula?

Take the figure shown for the gross profit over any given period and divide this monetary value by the total revenue of the business during that time. The result is a ratio, which is then multiplied by one hundred to express the gross profit margin as a percentage.

Gross Profit Margin (%) = (Gross Profit / Revenue) x 100

The main complication here is that people often describe the terms in this formula using different words for the same ideas. Yep, we hate that too.

For instance, revenue is often called total sales or turnover, and indirect costs are commonly known as the cost of sales or the cost of goods sold (COGS), especially for businesses that make or resell products. We take a deeper dive into the premise of gross profit here and this article also shows exactly how to calculate the gross profit margin.

What does gross profit margin reveal about a business?

Let’s look at an example. Avocado Ltd is a fictional business that makes and sells fruit-shaped furniture in London. In year one, its gross profit margin was 50%, based on a gross profit of £50k and revenue of £100k. These figures reveal that for every pound that Avocado Ltd took in sales revenue, the business made 50 pence in profit before it deducted indirect costs. ‌

YEAR ONE

Gross Profit Margin (%) = (£50k / £100k) x100 = 50%‌‌

In year two, Avocado Ltd achieved a gross profit of £70k based on twice the amount of revenue.  Naturally, the business is eager to present this news as a success. However, smart investors will notice that although the absolute level of gross profit and revenue both increased, the gross profit margin fell to 35% because the ratio of its gross profit to revenue dropped.‌‌

YEAR TWO

Gross profit margin (%) = (£70 / £200k) x100 = 35%‌‌

There are many possible reasons for this reduction. For instance, the cost of raw materials might have temporarily spiked, or the business shipping rates could have increased. The concern for investors is whether the gross profit margin fell because Avocado Ltd slashed its prices – and hence sacrificed that precious margin – to achieve this higher sales volume?

Is gross profit margin more important than net profit margin?

While gross profit provides only a snapshot of the underlying performance of the business, it can be a good indicator of the profitability of a specific product or service, especially when compared over different periods.

The issue with gross profit is that it does not take into account indirect costs to the business, such as rent or utility bills, whereas other profit metrics – for instance, net profit – do take these overheads into account. The same point is true for the gross profit margin, which is why net profit margin tends to be a more insightful figure.

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