Gross profit margin measures the proportion of profit yielded by sales. To calculate this ratio, divide gross profit by sales revenue:
Gross profit margin = Gross profit⁄Sales revenue
It is also knows as gross profit ratio or percentage.
Calculating gross profit margin
For the year ended April 2, 2016, Michael Kors Holdings Ltd. had gross profit of $2,797.2 million and revenue of $4,712.10. The company’s gross profit margin for that year was equal to 2,797.2/4,712.10 or 59.4%.
Michael Kors’ gross profit margin of 59.4% compares unfavorably with last year, 60.6%. However, it is higher than Ralph Lauren Corp.’s gross profit ratio of 56.5% for the year ended April 2, 2016, indicating that Michael Kors yields more profit from its sales than Ralph Lauren. Michael Kors either charges a higher markup on its products or makes them more cheaply than Ralph Lauren.
To better understand the meaning of a company’s gross profit margin, compare this ratio with prior years, looking for regular increases each year. Healthy companies can charge their customers a robust markup. Also compare your company with competitors. In general, competing companies’ gross profit ratios should be similar.
Profitability versus volume
Companies usually adopt different strategies to manage a trade-off between profitability and volume. Usually companies with valuable brand names (such as Ralph Lauren and Michael Kors) have the ability to charge high prices and limit volume. Companies that sell commodity types of goods (such as groceries) have little choice but to charge low, competitive prices and push up the volume. Consider the difference between an upscale department store, such as Nordstrom (36.5%) and a high volume discount store, such as Wal-Mart (25.1%).
Gross profit margin versus net profit margin
Gross profit margin is not the only ratio that analysts use to measure profitability. Analysts also use net profit margin, computed as net income divided by sales revenue. Gross profit margin focuses exclusively on one expense, cost of goods sold. However, net profit margin accounts for all of the expenses of a company, including selling, general, and administrative expenses and even income taxes. When setting prices, think about this trade-off between high prices and volume, and try to select a happy medium that will maximize your total profits.