Among the many metrics used in financial analysis and corporate performance management, gross profit margin is one of the most widely used. Understanding the concept of gross profit margin and how it is calculated and applied during analysis of financial performance is important when analyzing the overall profit potential of any business or product. While the concept of gross profit is important to understand, gross profit margin can provide powerful insight in a more granular and applicable way.
In this FAQ we will discuss what gross profit margin is, how it is different from gross profit, why it is important in financial analysis, and how to calculate it.
What Is Gross Profit Margin?
Gross profit margin is a metric that represents the percentage of gross profit as it relates to total net revenue. It is essentially the percentage of total revenue that remains after accounting for direct production and selling expenses. For example, if a product has a gross profit margin of 50% then for every dollar of revenue it generates, the business is left with 50 cents to allocate towards fixed expenses.
The Difference Between Gross Profit Margin And Gross Profit
The concept of gross profit margin goes hand-in-hand with gross profit, which is the amount of total revenue that remains after accounting for cost of goods sold and selling expenses. The difference between the two is an important distinction as gross profit margin is expressed in terms of percentages and gross profit is expressed in terms of dollars.
Both gross profit and gross profit margin are often used in conjunction to provide analysts with a more comprehensive picture of profit potential. While understanding gross profit is important, gross profit margin reflects how efficiently a business is utilizing its labor, supplies, and raw materials over time.
The reason that gross profit margin is used alongside gross profit is that it helps indicate if a business is becoming more or less efficient over time, regardless of the total dollars in gross profits the operations are producing. That is to say, profit margin might be increasing while total revenue and therefore gross profit is decreasing.
Analysts look for these trends to help determine how to better allocate resources to increase both gross profit margin and gross profit together.
Why Is Gross Profit Margin Used In Financial Analysis?
Gross profit margin is a useful indicator of a business’s ability to increase its efficiency over time. The expectation is that as a business continues to operate it will become more efficient and therefore profit margin will increase over time. This should happen regardless of the total gross profit created.
Monitoring gross profit alone often provides an incomplete picture of profit potential. This is because gross profit might be increasing over time while gross profit margin is shrinking. The only way to gain insight into this is to apply both gross profit and gross profit margin analysis in tandem.
Gross profit margin is also helpful in analyzing whether a business’s growth is sustainable or not. As a business grows it might deploy a variety of tactics to generate revenue. Calculating and analyzing gross profit margin will indicate if these efforts were worth it in the long run. For example, if increased sales result in increased production costs that go unmanaged then profitability might not be maximized.
Understanding gross profit margin is often used in the budget and forecasting process as well. Analysts will create forecasts of gross profit using their current or historical trends of gross profit margin. This makes creating a forecast easier and more straightforward than trying to guess what the total gross profit might be in a future period.
Its application is also helpful in modeling the impact of changes in operations that directly relate to the cost of goods sold. For example, if an investment is made today that significantly reduces the cost of goods sold in the future, then modeling the impact of the reduction is more easily done using gross profit margin.
How To Calculate Gross Profit And Gross Profit Margin
The formula for calculating gross profit margin is dependent on a handful of things. First, you must know the total net revenue or total revenue after rebates and discounts. Second, you must understand the cost of goods sold and what is included in that calculation. Finally, gross profit margin is calculated using gross profit, so it’s easiest to approach the formula in two steps.
Step 1: Calculate Gross Profit
Gross Profit = Total Net Revenue – Cost of Goods Sold
Step 2: Calculate Gross Profit Margin
Gross Profit Margin =Gross Profit Total Net Revenue
Because gross profit margin relies on the calculation of gross profit it is easy to calculate both simultaneously. This makes it easier to apply both during analytics and financial modeling. As such, both should be considered in the analysis of financial performance.
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