The gross profit margin or gross margin is a profitability ratio which is used to calculate how much amount of money left after excluding the cost of goods sold from revenues.In other words, the ratio describes what proportion of revenues exceeds the cost of goods sold (CGS).
The formula to calculate the ratio is:
Gross Profit Margin = [Gross Profit / Revenues] * 100
Gross Profit = Revenues – Cost of Goods Sold (CGS)
For the year ended 20xx, a Company A earns revenue of $1200 and incurs the cost of goods sold of $700. Calculate gross profit margin for the company.
Gross Profit = $1200 – $700 = $500
Gross Profit Margin = [$500 / $1200] * 100 = 41.67%
The higher gross profit margin indicates that more profit is available to cover operational and administrative costs. It is also helpful to determine how efficient the company is in terms of utilization of resources; more efficiency will result in reduced the cost of goods sold and increased gross profit margin.
It is a useful tool to compare companies but at some certain points, the ratio provides different answers like when your company pays attention to smaller customers for growth of revenues while other in the industry target all then due to increased administration cost of your company, the GP margin ratio will be higher than the industry average. Same like, larger manufacturers’ GP margin indicates its efficiency of production process whereas, for small retailers, it states their pricing strategy.