Gross profit margin or gross profit ratio simply measures how much gross profit entity has earned for one dollar of sales revenue made. Better the gross profit ratio better the entity’s ability to cover its operational, financial and other expenses of business.
Gross profit margin or gross profit ratio is calculated using the following formula:
= Gross profit / Revenue
Both gross profit and revenue amounts are taken from income statement of the entity for the given period. Gross profit is usually calculated by deducting cost of goods sold from revenue:
Gross profit = Revenue – Cost of Goods sold
A simple equation where excess of revenue over cost goods sold (CGS) is entity’s gross profit. If CGS exceeds revenue then entity will have gross loss in that period.
Cost of goods sold, as the name suggests, is the cost of goods sold and which is not necessarily entity’s cost of goods manufactured in that period. Cost of goods sold calculation for manufacturing business and retail business will be slightly different.
As retail business purchase the inventory and often sell it without further processing or conversion therefore its CGS calculation is usually straightforward as following:
CGS = Opening inventory + Purchases – Closing inventory
Where “Purchases” is net of all the costs necessary to bring the goods to entity e.g. import duty, carriage inward and also the amounts that are to be deducted i.e. trade discount and rebates.
Entities that manufacture their goods involve several elements in CGS calculation as raw material is converted to finished goods by applying labour and overheads. CGS in this situation can be calculated as follows:
|Raw material consumed||###|
|+ Direct labour||###|
|Cost of goods manufactured||###|
|+ Cost of opening finished goods units||###|
|Cost goods available for sale||###|
|– Costs of closing finished goods units||###|
|Cost of goods sold||###|
A simpler version of CGS for manufacturing concern can be:
CGS = Opening finished goods + Cost of goods manufactured – Closing finished goods.
Analysis and Interpretation of gross margin ratio
Just like other ratios, for better analysis and interpretation we need to have a benchmark so that we can compare. Benchmark can be gross margin ratio of last year, entity’s budget, competitor or industry average.
Entity’s gross margin ratio improves if it has increased or is higher than the benchmark. Better gross margin ratio is a result of either or both of the following:
- Increased overall sales revenue which can be achieved by raising per unit prices or selling more units by creating additional demand. The easiest of the two is to increase per unit prices but it does not always promise increased revenue as price per unit and demand (units sold) are inversely related. Depending on the nature of goods and resulting elasticity, increase in price per unit may cause significant decrease in units sold resulting in lower revenue instead. Alternative techniques include advertising, taping new markets where entity’s products are in demand etc.
- Decreased cost of goods sold which can be achieved either by decreasing overall cost or increased closing stock value. Entity can cut down cost by reducing cost incurred on input i.e. by using alternative raw material that is cheaper to buy or yields more finished goods for the same input thus reduced raw material cost per unit. Hiring cheaper labour force, training staff to reduce wastage and implementing new technology to reduce overhead costs.
Increased closing stock value will reduce overall cost of goods sold and result in higher gross profit. But this increase in gross profit is rather unfavourable as it indicates stock build-up indicating poor production and sales management or simply obsolete units sitting in entity’s warehouse probably requiring write-down.
From the above discussion we can realise that gross margin ratio require deep understanding of elements involved in calculation and also that increased gross margin ratio is not always favourable.