Gross profit margin (also called gross margin or gross profit margin percentage) is how much out of every sales dollar is left after Cost of Goods Sold (COGS) is subtracted from Revenue. Gross Margin is then used to cover a company’s operating expenses, interest, taxes, and profit. It is calculated by dividing gross profit by revenue.
Gross margin reflects the efficiency of the production capacity of the business, that is, the basic profitability of the goods or services themselves before expenses and overhead are considered.
Gross profit margin is calculated by simply dividing gross profit by revenue:
For example, if a company’s profit was $ 1,000 and its revenue was $ 8,000, then its gross profit margin is 12.5%.
This means that of every dollar this company makes, they get to use 12.5 cents in the course of business and 87.5 cents is what goes out or is used in the COGS or COS.
(Excerpts from Financial Intelligence, Chapter 21 – Profitability Ratios)
Gross profit margin is a key measure of a company’s financial health. After all, if you can’t deliver your products or services at a price that is sufficiently above cost to support the rest of your company, you don’t have a chance of earning a net profit.
Trend lines in gross margin are equally important, because they indicate potential problems. IBM not long ago announced great sales numbers in one quarter – better than expected – but the stock actually dropped. Why? Analysts noted that gross margin percentage was heading downward, and assumed that IBM must have been doing considerable discounting to record the sales it did. In general, a negative trend gross margin indicates one of two things (sometimes both). Either the company is under severe price pressure and sales people are being forced to discount, or else materials and labor costs are rising, driving up COGS or COS. Gross margin thus can be a kind of early-warning light, indicating favorable or unfavorable trends in the marketplace.