The Gross Profit Margin is a useful financial ratio to understand when analyzing a business’ profitability and performance. It allows us to see how much profit a business generates for every sale that it makes.
Before we go any further, it is crucial to understand what gross profit actually is. If you are unsure what gross profit is or how to calculate it, you can get a full re-cap here on one of our earlier posts. However, a basic explanation of gross profit is that is is the profit a business makes on all of its sales after taking off the costs of the goods sold (or services provided).
What Does the Gross Profit Margin Tell Us?
The margin tells us what percentage of every sale is gross profit – that is for every sale a business makes, how much money is left over to pay for its other operating expenses.
The gross profit margin is measured as a percentage and this is important to understand:
Gross profit is the actual amount of profit made on a sale in monetary terms (£)
The margin is a ratio showing how much profit is made per sale in percentage terms (%)
Essentially, for every £1 of sales made – what percentage of this is profit.
How is it calculated?
The formula for the GP margin is simple:
Gross Profit/Revenue * 100 = Gross Profit Margin (%)
If we break this down into simple terms, the formula above is literally saying what is the size of gross profit in relation to revenue?
We can plug in some simple numbers to test this:
Imagine a business sells one item for £100 and this item cost £50 to buy. In this example the gross profit would be £50 (£100 revenue -£50 cost of sales).
If we put this into the above formula this gives us a gross profit margin of 50% (50/100 * 100 = 50)
This means that for every £1 of revenue, half of this translated to gross profit for the business. Also, this means that the other 50% was cost of the sales and it is important to understand this as the margin can also be used to analyze costs as well as profitability.
Analyzing the Gross Profit Margin
When using the margin to analyze a business’ performance, we need to understand what the percentage really means.
The higher the margin %, the more potential there is for the business to be profitable. Remember, there are other costs to be taken off after the gross profit such as rent, wages, electricity etc. These are known as operating or administrative expenses. Therefore, the more gross profit we make from each sales, the more we will have left over to cover these expenses and make an overall profit.
A low profit margin tells us 2 things:
- Sales prices are too low
- Cost of Sales are too high
Either of these statements being true will lead to a lower gross profit margin but in reality it will probably be a combination of the two.
How do we Improve the Gross Profit Margin?
To improve the gross profit margin, we must reverse the two problems we listed above.
The simplest and quickest way to improve the margin is to raise sales prices. This is effective because the cost of sales remains the same and therefore the gross profit for every sale increases. Now for every £1 of goods we sell, the percentage of gross profit made is larger.
However, keep in mind the effect that raising sales prices may have on demand for your products. How much can the sales price increase before customers look to buy the product from somewhere cheaper? It is usually better to sell 100 items at a lower profit margin than raise prices and only sell 10.
We can also look to decrease the cost of goods sold:
To do this, we may try to negotiate discounts with suppliers for settling their invoices early or buying more products from them to receive bulk discounts.
Buying cheaper goods from other suppliers is also a possibility, but we must always keep in mind the quality of the goods which may decrease if we buy them from cheaper sources.
Summary
In summary, the gross profit margin tells us how much gross profit is being made on every sale we make. The margin helps us make business decisions when determining sales prices or negotiating purchases prices with suppliers.
The margin gets calculated as a percentage and normally, the higher the percentage, the better the margin is.
Related Posts:
We have other posts that will help you calculate the above ratio which are all part of our “understanding the income statement course”: