Any money left over goes to pay selling, general, and administrative expenses. which include salaries, research and development, and marketing. They appear further down the income statement. With all else being equal, the higher the gross profit margin, the better.
A Crucial Business Metric
The gross margin serves as a useful metric within industries and sectors, because it allows for a better apples-to-apples comparison among competitors. A company that sustains higher gross profit margins than its peers almost always has better processes and more sound operations. Those efficiencies could signal that the firm is a safer investment over the long term, as long as its valuation multiple isn’t too high. You can find the proper gross margin range for an industry by reading reports from research analysts, rating agencies, statistical services, and other financial data providers. Many brokerage firms also have research tools you can use. For instance, investors who have an account with Charles Schwab, one of the largest brokers in the U.S., get access to commentary and analysis from bodies like the Swiss bank Credit Suisse. The firm’s clients can download and read financial reports from many sectors, which include gross profit margin amounts. Other major brokers offer similar tools.
How to Figure Out Gross Profit Margin
You can figure out a company’s gross profit margin using this formula: Gross profit margin = gross profit ÷ total revenue Using a company’s income statement, you can find the gross profit total by starting with total sales and subtracting the line item “cost of goods sold.” This gives you the company’s profit after covering all production costs, but before paying any administrative or overhead costs, along with anything else that doesn’t directly factor into producing the company’s widgets.
Fictional Company Example
Let’s say you want to figure out the gross profit margin of a fictional firm called Greenwich Golf Supply. You can find its income statement at the bottom of this page in table GGS-1. For this exercise, assume the average golf supply company has a gross margin of 30%. Take the numbers from Greenwich Golf Supply’s statement, and plug them into the gross profit margin formula:
$162,084 gross profit ÷ $405,209 total revenue = 0.40, or 40%
The answer of 40% shows that Greenwich does better in the production and distribution of its product than most of its competitors. Once you know a firm has a better gross profit margin, the next question a potential investor, analyst, or competitor would want to ask is, “Why?” Why are Greenwich’s earnings better? Does it have a source of low-cost inputs? If so, can they keep it going? To see how gross profit margins can’t always hold up in the long term, take a look at the airlines. Certain airlines hedge the price of fuel when they expect oil prices to rise. This allows these firms to get much higher earnings per flight than other airlines. The benefit has limits because those hedging contracts expire. Therefore, the profit boost will not last.
Example With a Real Business
Let’s assume that most jewelry stores have gross profit margins of between 42% and 47%. With that in mind, how does Tiffany & Co. compare? To find the answer, dig into the firm’s 2019 income statement. For the time in question, Tiffany had a gross profit of $2,760,000,000 with sales of $4,424,000,000. When you put that value into the gross profit margin formula, you’ll discover that:
$2,761,900,000 ÷ $4,424,000,000 = 0.6240.624 converted to a percentage becomes 62.4%
When you look at these figures, Tiffany appears to do far better than its competitors. The gross profit margin suggests that Tiffany can convert more of each dollar in sales into a dollar of gross profit. These extra profits give Tiffany chances to build the brand, expand, and compete against other firms. When you dig deeper into the firm’s annual numbers in its 10-K filing, you see that this is due, at least in part, to its ability to get much higher sales per square foot than other jewelry stores. While Tiffany’s made around $3,000 per square foot in 2019, competitor Signet Jewelers (which owns Kay Jewelers, Zales, and Jared) made less than $2,000 per square foot.
Tracking the Gross Profit Margin
Most of the time, gross margins remain fairly stable throughout a company’s lifetime. Large ups and downs can be a warning sign of fraud, accounting irregularities, mismanagement, or a rise in the cost of raw materials. If you are looking at the income statement of a business and find its gross margin often averaged around 3% to 4%, but the most recent year saw its margins quickly shoot up to 25%, it should warrant a serious look. There may be a good reason for the increase, but you will want to know where, how, and why that money is being made. Using Tiffany & Co. again, you can see its gross margin stability over a five year period:
2015 gross profit margin = 61.0%2016 gross profit margin = 62.4%2017 gross profit margin = 62.6%2018 gross profit margin = 63.3%2019 gross profit margin = 62.4%
Table GGS-1
