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Gross Profit Margin: A Gauge of Cost Management

What is the Gross Profit Margin?

The gross profit margin is a measure of how much of a company’s revenue is left after subtracting the cost of goods sold (COGS). COGS is the cost of raw materials and labor to make the goods.

The gross profit margin gives an idea about how expensive it is for a company to produce the products and services it sells.┬áTherefore, it is a gauge of management’s efficiency to control the direct costs of revenue while maintaining or increasing revenues.

How to Calculate Gross Profit Margin

Gross profit margin is calculated by subtracting the cost of goods sold (COGS) from revenue, resulting in the gross profit, and then dividing the gross profit by revenue.

Both revenue and COGS are found on a company’s income statement.

Gross profit margin = (Revenue - COGS)/Revenue

How to Interpret Gross Profit Margin

While the gross profit itself doesn’t tell us much, the gross profit margin is very indicative of the company’s economic nature. It is instructive about a company’s financial health. 

The higher the gross profit, and the more consistent over many years, the better. Especially when compared to other companies in the same industry and/or with similar capital structure.

In contrast, a continuous downward trend in gross profit margin over several years is a red flag.

Gross Profit Margin as an Indicator of a Durable Competitive Advantage (Wide Moat)

According to Warren Buffett and the Interpretation of Financial Statements, the following gross profit margin characteristics are indicative of a durable competitive advantage:

  • Consistency over the past 10 years
  • In general, >40% gross profit margin is an indicator for a durable competitive advantage (but there are exceptions)

Comparison of Gross Profit Margins Between Competitors

One thing to consider when comparing gross profit margins between different companies is that comparisons only make sense between companies within the same industry. For instance, the cost structures of the automobile industry are much different from those of the online retail industry.

Note that even between companies in the same industry, a direct gross profit margin comparison does not necessarily make much sense if the total revenues are made up of vastly different types of revenue streams.

Example: Comparison of Gross Profit Margins in the Digital Marketing Industry

The graph below shows gross profit margins for public companies in the digital marketing industry. Most companies show very consistent gross profit margins above 40%. The exception is Dropbox Inc. (DBX), which started with a low profit margin of ~30%, but continuously improved it to ~80% between 2015 and 2020.

As mentioned above, a consistently high gross profit margin is an indicator of a durable competitive advantage. However, gross profit margin alone is not sufficient to establish whether a company has a moat, requiring the assessment of additional indicators. 

This becomes apparent when considering that as of this writing, only about half of the companies listed below benefit from a wide moat, as established by Morningstar‘s Moat Rating.

Gross profit margins of the digital marketing industry, 2011 to 2021.

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