Business owners, CEOs and managers monitor various types of margins and markups to keep track of which products perform the best, and which might need some help. As an investor, it's crucial to understand these margins so that you can fully understand what is included in company reports and so you can best determine which companies really have a handle on their business models.
Gross profit is net sales -- gross revenue less returns and chargebacks -- minus the cost of goods sold, divided by net sales. The "cost of goods sold" is the specific cost related to that individual product -- for retail companies this is the wholesale price, for manufacturers this is the cost of the parts that went into the product and any product-specific labor. Gross profit margin is useful when sectioned by individual products, product groups or business lines. That way, management can see which parts of the business make the most money based on the difference between cost and selling price.
It's important to clarify the difference between gross margin and markup. Markup is the difference between the wholesale cost of an item and it's selling price. Markup does not factor in discounts or chargebacks, and it expresses selling price as a percentage of wholesale -- how much greater is the selling price than the cost, rather than the gross margin, which is how many dollars of revenue it takes to make a dollar of gross profit.
Contribution margin goes one step beyond gross margin and adds fixed resources to the cost of goods sold. This includes salary, equipment and marketing costs, as well as selling costs like commissions. In many cases these expenses are allocated, or divided up, based on the amount of business in each sector or product. This shows the true cost of doing business, and may suss out products that have hidden costs in the form of employee time, equipment usage or sales costs.
Net Profit Margin
Like contribution margin, net profit is net sales minus all expenses, dividing this number by net sales to get the net profit margin. Unlike contribution, net profit looks at the whole company. This is the proverbial "bottom line" and over time reveals the profitability of the company. As a side note, remember that the cash value of net profit in any period is what pays dividends, if any, and becomes the next period's retained earnings.
- Microsoft Office; Three Keys to Profitability: Cost of Goods Sold, Markup and Margin; Stan Snyder, CPA
- Agricultural Extension Service at University of Tennessee; Selling Price, Gross Margin & Mark-Up Determination; Rob Holland; September 1998
- "Entrepreneur"; Gross Profit Margin and Markup; Rieva Lesonsky; August 2000
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