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Gross profit margin is a financial term used to refer to the actual profit made on a sold item. It is used to determine whether a company is financially sound. Investors often consider the gross profit margin when determining whether a company is a wise investment, and creditors and suppliers may also consider this margin when determining whether to extend credit.
When a company makes a product, there are costs associated with the production. For example, to produce a plastic toy, the company may have to pay a royalty to the designer of the toy, as well as pay for the cost of materials, manufacturing and distribution. Every tangible good has some costs associated with its production and sale. All of these costs are referred to as the cost of goods sold, which is sometime abbreviated using the acronym COGS.
Each item produced is then sold for a given price. For example, a company may sell its toy for $20 US Dollars (USD). The company then determines how much it made by the total number of toys it sold, times the cost. For example, if the company sold 100 toys for $20 USD, the company would make $2,000 USD on the toys.
This amount, however, does not factor in the cost of goods sold. The net profit, or the actual profit a company made, must be calculated to determine how much a company actually gained from the sale of the toys. If, for example, each toy cost $5 USD to make, then the net profit could be calculated by subtracting $500 USD, which is equal to the $5 USD cost times 100 toys.
The gross profit margin, on the other hand, is a metric that looks at how much a company made in relation to what its costs were. In order to determine the gross profit margin, the company must subtract the cost of goods sold from the revenue. Using the above example, the revenue was $2,000 USD and the cost of goods sold was $500 USD, leaving the company with $1,500 USD in profit.
The profit is then divided by the revenue to determine what percentage of revenue the company actually keeps. In the above example, the company would divide $1,500, the profit made, by $2,000, the total revenue. The result — 75 percent — is the company's gross profit margin; it reflects the percentage of profit made on each good sold.