What It Measures
The gross profit margin ratio measures how efficiently a company uses its resources, materials, and labor in the production process by showing the percentage of net sales remaining after subtracting the cost of making and selling a product or service. It is usually expressed as a percentage, and indicates the profitability of a business before overhead costs.
Why It Is Important
A high gross profit margin ratio indicates that a business can make a reasonable profit on sales, as long as overheads do not increase. Investors pay attention to the gross profit margin ratio because it tells them how efficient your business is compared to competitors. It is sensible to track gross profit margin ratios over a number of years to see if company earnings are consistent, growing, or declining.
For businesses, knowing your gross profit margin ratio is important because it tells you whether your business is pricing goods and services effectively. A low margin compared to your competitors would suggest you are under-pricing, while a high margin might indicate over-pricing. Low profit margin ratios can also suggest the business is unable to control production costs, or that a low amount of earnings are generated from revenues.
How It Works in Practice
To calculate gross profit margin ratio, use the following formula:
Gross profit margin ratio = Gross profit margin ÷ Net sales
First, determine the gross profit for the business during a specific period of time, such as a financial quarter. This is total revenue minus the cost of sales. The cost of sales includes variable costs associated with manufacturing, packaging, and freight, and should not include fixed overheads such as rent or utilities.
For example, if Company A has net sales of $10 million, while costs for inventory or production total $7 million, then the gross profit margin is $3 million. Next, divide this by net sales. In our example:
3,000,000 ÷ 10,000,000 = 0.3 = 30%
(Simply multiply the result by 100 to see it expressed as a percentage, here a gross profit margin ratio of 30%.) Tracking several subsequent quarters will allow you to create a more accurate profit margin ratio. A more detailed version of the formula is:
Gross profit margin ratio = (Total revenue – Cost of sales) ÷ Total sales
Tricks of the Trade
Gross profit margins tend to remain stable over time. Significant irregularities or sudden variations might be a potential sign of financial fraud, accounting irregularities, or problems in the business.
Gross profit margin ratios can be calculated alongside net profit margin ratios (net profit after tax ÷ sales), pre-tax profit margins (net profit before tax ÷ sales), and operating profit margins (net income before interest and taxes ÷ sales) to provide a more comprehensive insight into margins. Net profit margins and gross profit margins can be significantly different because of the impact of interest and tax expenses.
If you use an accounting program such as QuickBooks, the software can calculate gross profit margin ratios for you, making it easier to track margin ratios over several years. If you discover fluctuations regularly occur at a particular time of year, you might try to adjust pricing to encourage greater sales at that period.