Gross profit margin is the profit made on an item sold, used to determine a business’s financial soundness. It is calculated by subtracting the cost of goods sold from revenue and dividing the result by revenue. Investors, creditors, and suppliers consider it when making decisions.
Gross profit margin is a financial term used to refer to the actual profit made on an item sold. It is used to determine if a business is financially sound. Investors often consider gross profit margin when determining whether a business is a wise investment, and creditors and suppliers may also consider this margin when determining whether to extend credit.
When a company makes a product, there are costs associated with production. For example, to produce a plastic toy, the company may have to pay a royalty to the toy’s designer, in addition to the cost of materials, manufacturing and distribution. Every tangible good has costs associated with its production and sale. All of these costs are referred to as the cost of goods sold, sometimes abbreviated by the acronym COGS.
Each item produced is then sold at a certain price. For example, a company may sell its toy for $20 US Dollars (USD). The company then determines how much it made based on the total number of toys sold, multiplied by the cost. For example, if the company sold 100 toys for $20 USD, the company would make $2,000 USD on toys.
This amount, however, does not take into account the cost of goods sold. Net income, or the actual profit made by a company, must be calculated to determine how much a company actually made from selling the toys. For example, if each toy costs $5 USD, the net profit could be calculated by subtracting $500 USD, which equals the $5 USD cost per 100 toys.
Gross profit margin, on the other hand, is a metric that looks at how much a company made relative to what its costs were. To determine the gross profit margin, the company must subtract the cost of goods sold from the revenue. Using the example above, revenue was $2,000 USD and cost of goods sold was $500 USD, leaving the company with $1,500 USD in profit.
Profit is then divided by revenue to determine what percentage of revenue the business actually keeps. In the example above, the company would divide $1,500, the profit made, by $2,000, the total revenue. The result — 75% — is the company’s gross profit margin; reflects the percentage of profit made on each good sold.
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