Gross Profit Margin
What is the Gross Profit Margin?
Gross profit margin is a financial ratio that is commonly used when assessing the financial management and performance of a business. A higher gross profit margin, relative to the average industry benchmark or to previous trading periods, is an indicator of good financial management.
The gross profit margin is the amount of money remaining after deducting the direct expenses from the revenue, with the difference being expressed as a percentage of the revenue. Gross profit margin is used extensively in retail/wholesale businesses, where the direct costs are typically the Cost of Goods Sold (GOGS). Also known as Gross Margin, Gross Margin Ratio, Profit Margin, Margin of Profit, Gross Profit Percentage or just Margin.
What is the purpose of calculating the Gross Profit Margin?
Gross profit margin is a key performance measure that management, financiers and investors use to assess the financial performance of a business. By comparing the current gross profit margin with previous trading periods of the business and by comparing it with industry averages, stakeholders can make assessments about the financial performance of the management. A gross profit margin lower than previous periods and lower relative to industry averages may be a poor reflection on the financial management of the business.
How do you calculate Gross Profit Margin?
Gross profit margin is calculated using the formula:
Gross Profit Margin = (Revenue – Direct Costs) / Revenue x 100
- Revenue is the money that the business receives from its customers when they purchase the goods and services of the business.
- Direct costs are the costs that are required to make the revenue and which can be easily and directly attributed to the goods and services sold to the customer. Examples include the cost of purchasing goods (COGS) or the charge out cost of a person performing the service for a customer.
So if a business achieved $1,000 in revenue and the direct costs in achieving those sales was $600 then the Gross Profit margin would be = (1,000 – 600) / 1000 x 100 which = 400 / 1000 x 100 which equals 40%.
What factors impact on the Gross Profit Margin?
Changes in the Gross Profit Margin can be caused by many factors and should be investigated by management. These are:
- the business discounting or providing giveaways that are often used in promotional periods
- theft of goods either internally (staff) or externally (customers).
- management not increasing selling prices soon after suppliers have increased their cost price
- Staff incorrectly charging customers for goods or services
- Customers switching to goods or services with a lower gross profit margin
- Wastage in time or materials.
What is the Gross Profit Margin like?
A gross profit margin is like the money left over from a household budget after deducting the direct cost of housing (rent or loan repayment) from your wages (revenue). The left over money is then able to be spent on all the other needs of the household (indirect costs) with perhaps some savings left over at the end (profit). Expressing this situation by saying “we have about 60% of our wages left over after paying the rent” is the same concept expressed by a business that says “they have a gross profit margin of 60%”.
When do businesses typically calculate the Gross Profit Margin?
Gross profit margins are a key part of the management reporting system and so will be calculated and reported on monthly as part of the Profit and Loss statement. They will also be calculated whenever a new product is introduced into the assortment of the business, to ensure it meets the overall profit objective of the business.