What Is Gross Profit Margin?

Assessing a company’s financial health can be daunting without the right formulas and an understanding of how they each work. Profitability ratios like gross, operating and net profit margins can provide investors with the key information they need before investing their hard-earned money into a business that may not be generating enough revenue.

With the right information and data, choosing the right investments can be easy; given that, here we delve into the gross profit margin formula, the difference between gross profit and gross margin, as well as how to use this specific metric to make smarter investment decisions.

What Is Gross Profit Margin?

Gross profit margin is a key financial metric that falls under the profitability ratio category. Gross profit margin is a measure of the profit a company makes after considering its cost of sales. Cost of sales represents expenses related to labor, raw materials and manufacturing overhead used in the production process.

The most important aspect to remember is that gross profit margin measures how efficiently management uses labor and raw materials in the production process, and it is calculated as sales less cost of goods sold divided by sales.

What Does Gross Profit Margin Tell You?

Before investors buy a security, they should look at a variety of financial metrics such as gross profit margin.

Investors often use gross profit margin as a measure of how efficiently a company is running. Two companies in the same industry with widely different gross margins would typically indicate that the low-margin company is not maximizing its potential profits. Companies can boost gross profit margins by cutting costs such as labor and/or raising their prices on goods and services.

Gross profit margin provides investors with the amount of profit a company has made before deducting additional factors such as selling, general and administrative (SG&A) costs and taxes. Generally, gross profit margin is depicted in percentage format.

Analyzing a company based on its gross profit margin will tell you three main things about its overall business and processes, such as:

• Steadily decreasing gross profit margins can indicate a highly competitive market and product commoditization—a process in which a product is essentially deemed identical to the same class of offering presented by a rival company—which may be good indicators that the company will have difficulty in the future.
• If a company’s gross profit margin wildly fluctuates, this may signal poor management practices and/or inferior products.
• The company’s product pricing may need an adjustment if its gross profit margin is unusually high. Pricing is a delicate balance and certain pricing fluctuations may impact overall margin.

Additionally, gross profit margin can be used to more easily compare companies with different levels of sales revenues in the same industry.

Difference Between Gross Profit and Gross Margin

If you’re doing research, you may see gross profit and gross margin used interchangeably. Even though they both measure the profitability of a company, they have slight but key differences you’ll want to be aware of. If you’re an investor who wants to analyze a company thoroughly before buying its stock, you’ll want to understand the difference between gross profit and gross margin.

The main difference between gross profit and gross margin is that the first is a fixed dollar amount, while the latter is expressed as a ratio. When investors use gross margin to analyze a business, they are looking at a percentage that makes it easy to compare against the industry standard or competitors.

Lastly, gross margin makes it easy to compare various sized companies—for example, small to large companies—because gross margin percentages are expressed in proportion to the size of each company’s revenue and cost of sales.

How to Use the Gross Profit Margin Formula

Calculating gross profit margin does not have to be confusing. Subtract the total cost of goods sold or cost of sales (they are often used interchangeably) from the net sales and then divide that by net sales. Lastly, multiply that number by 100 to get the gross profit margin expressed in a percentage format.

If you don’t already have the net sales calculated, you can find the company’s net sales on its income statement or calculate it on your own by taking the gross revenue minus returns, allowances and discounts they have reported.

The gross profit margin formula looks like this:

[(Net sales – cost of sales) ÷ net sales] × 100 = % gross profit margin

Learn how to take advantage of the gross profitability premium.

How Is Gross Profit Margin Used to Calculate Profitability?

You may be wondering why gross profit margin falls under the profitability ratios category. That’s because it’s one of most common ways to gauge a company’s profitability. As a rule, gross profit margin is one of the simplest profitability ratio metrics because it defines profit as the income remaining after the company accounts for the cost of goods sold during a certain time frame.

As mentioned above, it’s also an indicator of executive management and how companies make a profit as well as whether they’ve accurately priced their goods or services.

Overall, investors who know how to calculate and analyze a corporate profit margin, such as gross profit margin, gain insight into a company’s current effectiveness in generating revenue and its potential to generate future profits. Of course, calculating a company’s gross profit margin formula is just the starting point, and you will want to analyze several ratios and other metrics before investing your hard-earned cash into a business.

What Is a Good Gross Profit Margin?

Unfortunately, there is no universal standard for a bad or good gross profit margin. This is because gross profit margins vary drastically by industry. However, companies with relatively high gross profit margins typically have more of a chance of staying profitable if market conditions worsen.

In general, companies whose products or services are not material- or labor-intensive have higher gross profit margins. Cost of goods sold is the cost of acquiring or manufacturing the products that a company sells during a period, so the only costs included in the measure are those that are directly tied to the production of the products, including the cost of labor, materials and manufacturing overhead.

For example, you can look at a company like Tesla Inc. (TSLA). Tesla’s gross margin is 23.1% as of January 2022. You can compare that to the industry median of 19% in January. Comparing Tesla’s gross profit margin to the industry average helps you to evaluate how it stacks up to other similar auto companies. You can also compare Tesla’s current gross margin to its historical levels. For example, its five-year average gross margin is 24.5%.

Analyzing Tesla’s gross profit margin is more significant than for other companies because it internally considers gross profit as a key indicator of success. This is because Tesla is constantly seeking to reduce the cost of producing its electric vehicles to stay on top of the competition.

Where You Can Find a Company’s Growth Profit Margin

Finding a company’s growth profit margin is relatively easy, especially if you have a dashboard like AAII’s Stock Evaluator pages. There is a clearly marked Ratios tab where you can find all profitability ratios—operating margin, net margin and gross profit margin—listed out for each security. There, you can see the industry median for these ratios so you can easily compare a stock relative to that of similar competitors. AAII’s Stock Evaluator pages also have historical data so you can look at how a company’s gross profit margin has changed over the years.

On the AAII website, you can also compare and contrast various stocks using screeners that help you to find potentially profitable stocks .

It’s important to note that not all companies disclose the cost of goods sold on their income statements, notably financial and other service-related companies. Therefore, in some cases, it is not possible to calculate the business’ gross profit margin and you will have to analyze other profitability ratios or financial metrics.

Difference Between Gross Profit Margin and Net Profit Margin

The main difference between gross profit margin and net profit margin is that the latter removes interest, taxes and operating expenses from net revenue to arrive at a more conservative figure.

The gross profit margin formula will always result in a higher figure than the net profit margin because the gross profit margin does not include any selling and administrative expenses—for investors, that might be considered incomplete data that doesn’t look at the overall picture.

Lastly, the reason you’ll want to look at operating, net and gross profit margins rather than just one of these metrics is that gross profit margin is more likely to incorporate a high proportion of variable expenses, including the direct materials required to generate sales. In contrast, the net profit margin contains a much lower proportion of variable expenses, since it also includes selling and administrative expenses, many of which are considered to be fixed costs.

Using the Gross Profit Margin Ratio Formula to Invest

Investors can utilize profitability ratios like gross profit margin to more accurately gauge the future of a company and develop a feel for its attractiveness as measured on factors such as its financial health and overall profitability for a specific time frame.

Knowledge of how to use all three of the main profitability metrics—gross, net and operating profit margin—gives investors a feel for how efficiently a company has generated revenue in the past and how well it will do in the future. Understanding how a company’s business model and processes generate revenue and earnings—which impact share prices and shareholders—and whether it is becoming efficient at controlling costs is crucial before investing your money into a security.

AAII offers the individual investor a long list of helpful educational tools, resources and stock metrics to help people invest their money wisely. Subscribing to our A+ Investor service provides members with customizable stock grades and screens, and new enhancements to the service are added quarterly.

Members can search any company on the AAII website to see specific stock metrics for different types of investing approaches, including ways to measure a company’s worth and viability with margins and ratios.

You can use A+ Investor to vet various market securities like stocks, bonds, funds, etc., with key financial metrics, professional screens and power rankings. The A+ Investor service helps investors take control of their financial destiny, educating them every step of the way. If you’re ready to start analyzing your stocks’ profitability ratios like gross profit margin and other important factors, subscribe to A+ Investor today.