The gross profit margin is a profitability ratio that compares a company's gross profit to its revenue in the period under review. It shows how much profit a company makes after paying off its Cost of Goods Sold (COGS).
Furthermore, the COGS is the total cost incurred to sell a product. We can calculate the COGS by subtracting total revenue from gross profit.
The gross income margin ratio shows the percentage of each dollar of revenue that the company retains as gross profit.
For example, if after calculation, a company's gross income margin is 20%, this means that for every dollar of revenue generated, the company retains $0.20 while the remaining $0.80 goes to the cost of goods sold. The remaining amount can be used to settle general and administrative expenses, interest expenses, debts, rent, overhead, etc.
Gross Profit Margin Formula
The gross profit margin formula is expressed as;
Gross Profit Margin = (Revenue – COGS) ÷ Revenue
It can be further simplified as;
Gross Profit Margin = Gross Profit ÷ Total Revenue.
Calculation Of Gross Profit Margin
It is easier to calculate the gross income margin if a company has a good bookkeeping system. You can get the gross profit, revenue and COGS for the period under review from the income statement.
Calculation Of Gross Profit Margin Example
For example, a company's revenue is $500,000; its cost of goods sold is $200,000, leaving a gross profit of $300,000.
To find the gross profit margin, you will divide the gross income by the total revenue.
$300,000 ÷ $500,000 = 0.6 gross profit margin
To express it as a percentage, we will multiply 0.6 by 100, which is 60 percent in this instance.
0.6 × 100 = 60%
This means that for every revenue dollar the business generates 60 cents in profits before payment of other business expenses.
How to Increase the Gross Profit Margin Ratio
The ratio measures how profitably a company can sell its inventory. A higher ratio is more favorable. There are typically two ways to increase the figure:
1. Buy inventory at a cheaper price
If companies can get a large purchase discount when they buy inventory or find a cheap supplier, their ratio will increase because the cost of purchasing inventories will be lesser.
2. Mark up goods
Marking up goods means selling goods at a higher price. This would result in a higher ratio. However, this must be done competitively – otherwise, the price of goods would be too expensive, resulting to lose of customers and only few customers would purchase from the company.
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