If you looked at the profit and loss statement of a major company and discovered it had generated $17 million in sales revenue, it would appear that the company is turning a hefty profit. But take a closer look at the income statement and you might be surprised to discover that the company had spent $16.8 million in that same accounting period. You then would realize that its profit margins are rather modest. That’s because the company is spending nearly as much money as it’s receiving from gross sales.
Companies can measure the efficiency of their operations by calculating their gross profit margin ratio, also known as a gross margin ratio. This ratio compares gross profits to the direct costs that go into manufacturing and selling a company’s products. Higher gross margins typically indicate a more profitable company.
What is gross margin ratio?
Gross Margin Ratio, also known as Gross Profit Margin, is a financial metric that measures a company's profitability by comparing its gross profit to its net sales. It is expressed as a percentage and helps businesses understand how much money is left after covering the cost of goods sold (COGS).
How do you calculate the gross margin ratio?
You can calculate gross profit margin ratios with the use of two inputs: total revenue and cost of goods sold.
- Total revenue. This figure represents the gross sales from a particular product or service.
- Cost of goods sold. This figure describes all the direct costs related to the production of that product or service. Direct costs include labor, raw materials, and equipment. They do not include other costs like business administration expenses, marketing expenses, or taxes.
Plug these inputs into the following formula:
Gross Margin Ratio = (Total Revenue - COGS) / Total Revenue
This produces a ratio (that can be converted to a percentage) that reflects whether or not a company is efficiently manufacturing its product offerings. A high gross margin ratio indicates efficiency; a lower gross margin efficiency suggests a process that could be improved.
For example, imagine a shoe company that earns a gross profit of $28.7 million from sales of its athletic sneakers. The company carries a cost of goods sold that totals $19.248 million, which includes raw materials, factory equipment, and employee salaries. When plugged into the gross margin ratio formula, these numbers looks like this:
Gross Margin Ratio = (28,700,000 – 19,248,00) / 28,700,000
This yields a gross margin ratio of 9,452,000 / 28,700,000 = 0.32933 multiplied by 100, which converts to a 32.9% profit margin.
Gross profit margin vs. net profit margin
While the gross profit margin measures the profitability of a production process, net profit margin considers all of the expenses a company takes on—not just the ones linked to production.
To find a company’s net margin, tally the cost of goods sold along with indirect operating expenses, interest expenses, and tax expenses. Combine all of these line items into a single metric called total expenses. Concurrently, tally up the company’s total revenue from all activities, whether those are direct operating activities (like selling a signature product) or indirect activities (like collecting interest from a loan). These combined incomes are called total revenue.
Plug these two items into the net profit margin formula:
Net Profit Margin = (Total Revenue - Total Expenses) / Total Revenue
You can think of the numerator, or top number, in this equation as a company’s net sales, since it tallies all revenues and subtracts all expenses. When you calculate the difference and divide it by total revenue, you get your net profit margin.
Returning to the example of the shoe company with a 32.9% profit margin, imagine that it spends $4.3 million on non-operating expenses. When this is added to the $19.248 million it spends on operating expenses, the expense total becomes $23.548 million.
Plugging this into the net profit margin formula looks like this:
Net Profit Margin = (28,700,000 - 23,548,000) / 28,700,000
This produces a net margin ratio of 5,152,000 / 28,700,000 = 0.1795 multiplied by 100, which converts to a net profit margin of 17.95%.
What makes a “good” gross margin ratio?
As a general rule, higher gross profit margins indicate more profitable companies. A high ratio suggests that the company is not spending too much of its revenues on production expenses like salaries and raw materials.
In real world practice, different industries operate at different gross margin ratios. The banking industry has a famously high gross profit margin (hovering around 99%) while the airline industry operates at notoriously low profit margins (roughly 6% in 2019).
Notably, high gross profit margins do not always equal high net margins. In many cases, net margins run far lower than gross margins due to factors like interest expenses and tax expenses. This means that even if businesses can reign in its cost of goods sold, other costs (like administration, sales, and interest payments) can weigh down their bottom line.
Gross margin ratio FAQ
How do you calculate gross margin ratio?
You can calculate the gross margin ratio using this formula: Gross Margin Ratio = (Total Revenue - Cost of Goods Sold) / Total Revenue
What is the gross margin profit ratio?
The gross margin profit ratio is the same thing as the gross margin ratio: Margin Profit Ratio = (Total Revenue - Cost of Goods Sold) / Total Revenue
What does the gross profit ratio indicate?
The gross profit ratio compares a business’s revenues to the costs directly related toward generating those revenues. For instance, a pizzeria’s gross profit ratio compares the revenues from selling pizza to the direct costs that go into making that pizza (raw ingredients, labor, machinery). A high gross profit ratio indicates that the company is generating a good amount of profit from its core operations and is not spending too much of its revenue on sustaining those operations.