Gross Profit Margin
Gross Profit Margin is the profitability ratio measure by the percentage of gross profit over revenue. Gross profit is the remaining balance of revenue after deducting the cost of goods sold. It is used to access company financial health by calculating the remaining amount to spend on operating expenses such as payroll, marketing, and other administrative expense.
Revenue refers to sale amount which excludes discount and sale return which also known as the net sale. It is the income company make from a certain product type within the accounting period.
Cost of goods sold is determined by the total cost of acquiring or manufacturing the products. It will include material, labor, and manufacturing overhead. There are several ways of calculating the cost of goods sold such as absorption costing, activity-based costing, process costing.
Gross Profit Margin Formula
Gross Profit Margin is the percentage of gross profit over the sale. In order to calculate the Gross profit Margin, we use the following formula:
| Gross Profit Margin = (Revenue – COGS) / Revenue |
Gross Profit Margin Example
Company ABC is a shoe manufacturing, the cost of production include material, worker wage, and overhead cost. During 202X, the company generates a net sale of $ 2,000,000, and base on the calculation, the cost of goods sold equal to $ 1,200,000. Please calculate the gross profit margin during the year.
Gross profit margin = (2,000,000 – 1,200,000)/2,000,000 = 40%
Analyze Gross Profit Margin
Within the same industry, the company which makes higher gross profit margin show that they will make a higher net profit for the shareholders. They have a higher amount for spending on operating expenses and the remaining is the profit.
It shows that company good at converting the material into the final product in an efficient way. Many shareholders will take a closer look at the gross profit margin and compare with the other player in the same industry.
Gross profit margin should be similar from year to year if it highly fluctuates it shows something is not right. The variables, selling price, and total cost has significantly changed over time. The change must be investigated as it will show the weakness of the company in control cost or pricing strategy.
What Is a Good Gross Profit Margin?
We may think that the higher-margin is better as we will make more profit. But it is not always the case, different industries, products, and locations will have a different level of gross profit margin. The food industry has a huge gross profit margin of around 70% while other businesses such as construction can make around only 20%. By looking at these percentages and make judgments about company performance.
The reason is the relationship between direct and indirect costs. The restaurant usually spends a lot on operating expenses such as payroll, utilities, depreciation, rental, and so on. So we need to make a huge profit margin to cover the operating expense and left with some profit.
On the other hand, the construction industry pay a huge amount on material and labor while the operating expense is very low compare to contract price. Moreover, a small percentage of gross profit is more than enough to cover operating expenses due to the huge contract price.
In conclusion, a good gross profit margin is the percentage that company use to pay for the operating expense and remain some profit for the shareholders. However, it should not too high as it will increase the selling price which can impact customers and reduces sales. As a result will decrease the sale amount, gross profit, and net profit. The company tries to use different methods such as Target Costing, Life cycle costing, in order to determine the correct costing which leads to the proper margin.
How to improve Gross Profit Margin
Increase selling price: yes it just simple math, the company can simply increase the price to increase margin when the product cost remains the same. However, this will decrease sales as customers look for other alternatives. It will end up decreasing revenue and profit if we play it wrong.
Reduce the cost of goods sold: It is an awesome strategy to increase gross margin without touching the selling price. But the company must ensure that the products’ quality is not sacrificed due to lower cost. Otherwise, it will give a bad impact on the long term sale.
Sensitivity Analysis: It is a strategy in which the company tries to optimize the sale and price and gross profit. We will try to push the price to an optimized level which not significantly impact the total sale. By doing so, we will be able to maximize our profit which is the ultimate goal of maximizing gross profit margin.
Use bundle product strategy: the company may sacrifice the profit margin of one product to maximize another one. In total, we will get a high margin. You can read more about the bundle pricing strategy in the link.
Advantage
Easy to calculate: it is a simple calculation in which everyone can do it.
Easy to compare: as everybody doing this calculation, we will be able to compare with the industry average as well as the competitor. As we have to aware of competitors’ margin as our customers may move from us due to the pricing. Gross profit margin allows us to compare and keep the margin similar to competitors.
Pricing strategy: by keeping the gross profit under control, the company will try to adjust the selling price and cost of goods sold to achieve the desired level of margin.
Disadvantage
It does not include all costs: this margin only uses the cost of goods sold which will not tell the whole story. Company with a high gross margin still making losses if it can not cover high operating expenses. On the other hand, the low gross margin will make a profit if the operating expense is low.
Hard to use alone: it is almost impossible to access the company performance by using gross profit margin alone, it must be used alongside other tools and matric.
Not suitable for cross-industry comparison: as we have mentioned, there is a huge gap between industry margin. It is very hard to compare from one industry to another.
Misleading: if investors rely on gross profit margin to judge the potential growth of the company, it will be a huge mistake. Company may reduce the price to capture market share, so the gross profit margin will be lower or even negative, but it does not mean the company will not make a profit in the future.