Gross profit margin is a financial metric used to determine a company’s profitability by subtracting the cost of goods sold from revenue and dividing the result by revenue to get a percentage. It is used by investors, creditors, and vendors to assess a company’s financial health.
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 company is financially sound. Investors often consider gross profit margin when determining whether a business is a wise investment, and creditors and vendors may also consider gross profit margin when determining whether to extend credit.
When a company makes a product, there are costs associated with the production. For example, to produce a plastic toy, the company may have to pay a royalty to the toy’s designer, as well as pay for the cost of materials, manufacturing, and distribution. Every tangible good has some costs associated with its production and sale. All of these costs are known as the cost of goods sold, which is sometimes abbreviated using the acronym COGS.
Each item produced is 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 earned by the total number of toys it sold, multiplied by the cost. For example, if the company sold 100 toys for $20, the company would earn $2,000 on the toys.
This amount, however, does not take into account the cost of goods sold. Net profit, or the actual profit a company made, must be calculated to determine how much a company actually made from the sale of the toys. If, for example, each toy costs $5, then the net profit could be calculated by subtracting $500, which is equal to the cost of $5 for 100 toys.
Gross profit margin, on the other hand, is a metric that looks at how much a company earned relative to its costs. 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 and cost of goods sold was $500, leaving the company with $1,500 in profit.
The profit is then divided by the revenue to determine what percentage of the revenue the company actually keeps. In the example above, the company would divide $1,500, the profit made, by $2,000, the total revenue. The result, 75 percent, is the company’s gross profit margin; It reflects the percentage of profit obtained for each good sold.
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