how to calculate gross margin ratio

The gross margin and the net margin, or net profit margin, are frequently used in tandem to provide a comprehensive look at a company’s financial health. It can be used to (1) evaluate profitability, (2) help set pricing, and (3) make comparisons between peers. While the gross margin only accounts for a company’s COGS, the net margin accounts for COGS plus all indirect, interest, and tax expenses. For example, if the ratio is calculated to be 20%, that means for every dollar of revenue generated, $0.20 is retained while $0.80 is attributed to the cost of goods sold. The remaining amount can be used to pay off general and administrative expenses, interest expenses, debts, rent, overhead, etc. Gross margin is concerned with the link between revenue and cost of goods sold; net profit margin considers all of a company’s expenses.

Gross Profit Margin Calculation Example

  1. Because it works in a service business with low production costs, a legal service company, for example, claims a high gross margin ratio.
  2. The problem is that certain production expenses are not entirely changeable.
  3. The best way to assess a company’s gross margin number is to conduct a long-term analysis of trends, comparing the company to itself, or to compare it to peers and the sector average.
  4. On the other hand, an automobile manufacturing business will have a lower ratio due to higher production expenses.
  5. We can use the gross profit of $50 million to determine the company’s gross margin.

This figure is then divided by net sales, to calculate the gross profit margin in percentage terms. On the other hand, an automobile manufacturing business will have a lower ratio due to higher production expenses. Therefore, the gross profit margin is the first of three primary profitability measures. Despite the widespread usage of gross profit margin ratios, many consider their drawbacks. The problem is that certain production expenses are not entirely changeable.

how to calculate gross margin ratio

Labor costs

Gross profit margins can also be used to measure company efficiency or to compare two companies with different market capitalizations. For example, a higher gross profit margin indicates that your business is financially sound and able to produce products and services efficiently and profitably. This premium vs discount bonds profitability ratio evaluates the strength of a company’s sales performance in relation to production costs. It’s important to compare the gross profit margins of companies that are in the same industry. This way, you can determine which companies come out on top and which ones fall at the bottom.

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Gross profit represents the actual dollar amount generated from a company’s core operations before considering other operating expenses. Gross profit does not consider the proportion of profit relative to net sales revenue. You can either calculate gross profit yourself using the companies’ income statements or look up the companies on a financial data website, which is probably the quickest. A company’s operating profit margin or operating profit indicates how much profit it generates under its core operations by accounting for all operating expenses.

A surge in demand can allow companies to command higher prices, potentially boosting the gross margin. Conversely, a decrease in demand might necessitate discounts or promotions, which can depress the margin. Another way to interpret a gross margin number is to compare it to the sector average and top competitors during the same period, such as annually or quarterly.

Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. COGS is the cost of goods sold and is subtracted from revenue to get the gross margin, which is then divided by the revenue to get the ratio amount. Additionally, revenue is sometimes referred to as the top line since it stands on top of the income statement.

Investors can compare a company’s gross margin to industry averages and competitors to assess whether the company’s gross profit is healthy and sustainable. In general, the higher the gross margin, the more revenue a company retains per dollar generated. However, keep in mind that other factors can impact this figure, such as industry, company size, and other external factors. Net profit margin is a key financial metric that also points to a company’s financial health. Also referred to as net margin, it indicates the amount of profit generated as a percentage of a company’s revenue.