Gross Profit Margin
What it is:
How it works (Example):
The top number in the equation, known as gross profit or gross margin, is the total revenue minus the direct costs of producing that good or service. Direct costs (COGS) do not include operating expenses, interest payments and taxes.
To illustrate, let's say Company ABC makes shoes. If ABC reported $5,000,000 in total revenue for the year and cost of goods sold (cost of materials and direct labor) of $2.5 million, then we can use the formula above to find ABC's gross profit margin:
Gross Profit Margin = ($5,000,000 - $2,500,000) / $5,000,000 = 50%
The gross profit margin percentage tells us that Company ABC uses 50% of its revenue to pay for the direct costs of making its shoes. The rest can be used for operating expenses, interest, taxes, dividend payouts, etc.
Why it Matters:
Gross profit margin is a key measure of profitability by which investors and analysts compare similar companies and companies to their overall industry. The metric is an indication of the financial success and viability of a particular product or service. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.
Analysts are constantly asking themselves, "Why can some industries maintain profit margins that are so much higher than others?" The answer lies with Porter's Five Forces, a classic business framework for discovering which firms will outperform the competition. To learn more, click here to learn about Using Porter's Five Forces to Lock In Long-Term Profits.