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Gross margin is the percentage of net sales (net sales = sales – reimbursements) that exceeds a company’s cost of goods sold (also known as the direct cost of materials and labour).
Gross profit margin = (net sales – cost of goods sold) / net sales.
Understanding gross profit margin
A higher gross profit margin (GPM) usually indicates that a company is more efficient and financially stable than other companies in the same industry. There are two reasons for this: Either the company has low direct production costs (if it sells at the same price as its competitors), or the company is able to charge more than its competitors (perhaps because of the strength of its brand). All in all, gross profit margin can be a helpful indicator of a company’s financial health. The company with the highest gross profit margin may not always be the best (it could have a high gross profit margin but low sales if its products are overpriced), but it is still a fairly reliable indicator that a company is doing well.
According to Apple’s 2018 income statement, the company’s gross profit was $101.8 billion on revenue of $265.6 billion. Let’s apply these numbers to the formula for calculating gross profit margin (see above).
101.2B/265.6B x 100 = 38%
This means that Apple had a gross profit margin of 38% in 2018.
Source: Apple Q4 FY18 Consolidated Financial Statements
Put another way, think back to when you were 12 years old and decided to mow your neighbour’s lawn for $10. That $10 bill is what constitutes “net revenue.”
Let’s say your dad took $2 as a rental fee for the use of his lawn mower and another $0.50 for the gasoline used in mowing. That leaves $7.50 ($10 – $2.50 = $7.50). The $2.50 is the cost of doing business. The remaining $7.50 is your gross profit.
Although you received $10 from your customer, you may only keep $7.50 of it for yourself. In other words: Your gross profit was 75% of your net sales ($7.5/$10). You’d call this percentage “gross profit margin” (also called “gross margin”).
Gross profit margin is like leftover pizza…
Although the delivery man gives you a whole cake, all your guests take a piece. When everyone has finished eating, you may save the leftover portion for tomorrow. If you put 3 out of 8 slices in the refrigerator, your profit margin is 37.5% (3 pieces / 8 pieces).