Profit Margin Formula – Explained

Gross profit margin or profit margin refers to the ratio of left revenue (in dollars) after paying the cost of goods to revenue. i.e, it is basically profitability ratio that measures how much revenue (in dollars) is left after paying the cost of goods that are sold, delivered or under services.

It measures the efficiency of the company to use its raw materials, labor and resources in the production process. Its values differ from company to company and an industry to industry.

The higher the profit margin the higher the ratio and the higher the GPM, that more the efficiency of the company.

profit margin formula

Gross Profit Margin ratio= (revenue – Cost of goods sold)/revenue.

The numerator value is called as Gross Profit or gross margin. It is a difference in total revenue and total and direct cost of making goods. It must be noted that other costs such as interest payments, taxes, shipping charges, damages, and operating expenses are not included in this direct cost.\

Let us consider an example:

There is a company XYZ that manufactures auto parts, it collects revenue of 10,000 dollars and spends 3000 dollars on manufacturing the parts. So after putting that values in the above relation, we get Gross profit ratio (here) as 30%. It shows that this company can spend the rest money (30%) in this case, in interest payments, taxes, and other pay-outs.  

It is an indicator of the company’s financial health. Investors look for this data when it comes to make an important decision involving investment and shape their investment strategies. It shows how much a company is earning per dollar in revenue. As long as a company assures less expenditure on overhead expenses, it can make a larger and reasonable profit on sales. With a much higher gross profit margin percentage.

While with such a useful analysis and plenty of work go around. There are some issues also, that relate to the gross profit margin ratio. Let us know what they are.

The issue is that some products have nearly constant production costs, it is seen that they only cost “material” so remaining costs are spent on other pay-outs which increases the ratio much larger than it is originally. So what happens here is that some businesses and companies apply a slightly different formula for that gross profit margin.

That is,

Gross profit margin (new) = (Revenue- Direct materials)/Revenue

So anytime it happens that your company has a pricing issue, then directly check your gross profit ratio at first glance, it may or may not be calculated properly. It is very probable that here the problem lies. And learn how to price effectively and profitably.

One more thing to look forward here when we are discussing gross profit margin is,

“How come companies maintain such high gross profit margin ratio?” is a must ask the question by all new entrepreneurs over there, and it should be asked. The term you must look forward to is, “Porter’s five forces”. It is a classic framework in business that helps you discover which firs will outperform the competition.

Some people confuse Gross profit Margin with net profit margin, which needs to be understood properly. Net profit margin indicates how much profit a company makes with its total sales achieved. Higher net profit margin shows how much a company is successful in making sales into actual profit. While in gross profit fixed costs are excluded, plus the analysis it isn’t the same as the Net profit margin.  In NPM ratio, all costs are involved which is related to business and profit.

For net profit margin ratio calculation, skills from an owner of a small business to experienced CFO everything is needed. Depends upon the complexity of the company.

A formula for NPM ratio is:

Net profit margin ratio=Monthly net income/net sale.

So we are now clear about our concept if Gross profit margin. Happy Business!  

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