Making profits is the ultimate goal of any business. Analysts and investors often focus on the net profit of a business to determine investment decisions. However, the first step to making a profit is having a positive gross profit margin. Here are more details for you!
Read More: Net Profit Margin – All you need to know
What is the meaning of gross profit margin?
Gross profit refers to the profit earned by a business after deducting the cost of goods sold from its sales or revenues. This gross profit is then expressed in terms of percentage by dividing it by the revenues or sales for the period to derive the gross profit margin. Unlike net profit, gross profit does not include additional costs or expenses of a business like general administrative expenses, sales, and distribution expenses, etc. Rather it covers only the expenses incurred by a company to produce or acquire the products or services that it sells. This includes the direct costs of materials, labor, and overhead expenses that are directly tied to the production or acquisition of the goods or services.
What is the formula to calculate gross profit margin?
The first step to calculating gross profit margin is to calculate the gross profit of a company. The formula to calculate the gross profit of a company is given below,
Gross profit = Revenue or Sales – Cost of goods sold
In the above formula, revenue represents the total amount of money earned from selling goods or services. The cost of goods sold represents the direct costs associated with producing or acquiring those goods or services.
The formula to calculate the gross profit margin is,
Gross Profit = (Revenue – Cost of Goods Sold) / Revenue x 100 or,
Gross Profit Margin = Gross Profit / Revenue x 100
The above formula is explained through an example.
Company A has revenues of Rs. 1,00,000 and a cost of goods sold (COGS) of Rs. 60,000. The gross profit margin in this example is calculated as under.
Gross profit margin = (100000-60000) / 100000 x 100
Therefore, Gross Profit Margin = 40%
What is the importance of gross profit margin?
The gross profit margin is a crucial financial metric that is used to understand various aspects of the business. The importance of the same is highlighted here.
- Measure of profitability
Gross profit margin is a direct measure of the profitability of a business and its ability to generate profits over its cost of production and sales. When a company has a higher gross profit margin, it indicates a higher profit made through each sale whereas a lower gross profit margin needs deeper introspection in terms of higher costs or poor pricing policy, or other factors.
- Evaluation of effective pricing policy
This can be a crucial parameter in deciding the pricing policy of a business. A company with a higher gross profit margin can indicate a better pricing policy than its peers or the advantage of lower costs. On the other hand, a business with a poor GPM can indicate loopholes in its pricing policy and its need for revision.
- Comparing the performance of the business
Gross profit margin is also one of the many indicators of comparing the financial health and performance of the business with itself as well as with its peers in the industry. Such exercise can help in understanding key areas that need management attention or revision of organisational policies that can lead to better efficiency and help the business gain a competitive advantage.
- Efficiency in cost management
The gross profit margin is also a strong indicator of a company’s ability to manage its cost. A business with a lower gross profit margin can indicate a business with higher costs than its peers or an inefficient cost structure. Similarly, a business with a higher gross profit margin can indicate a business with efficiency in cost management.
What are the factors that impact the gross profit margin?
There are several factors that can impact a company’s gross profit margin. Some of such factors are mentioned hereunder.
- Pricing
The prices of the final product have a direct impact on the gross profit margin. A business having a poor pricing policy will see a lower or negative gross profit margin. On the other hand, a business with an optimum pricing policy will see better margins to sustain other expenses of the business.
- Cost of goods sold
The cost of goods sold refers to the direct expenses that are incurred in the production of final products or services. The gross profit margin is therefore indirectly proportional to the COGS.
- Competition
The level of competition in an industry also has a direct impact on the gross profit margin. An industry with higher competition will require businesses to price their products and services more competitively to attract or retain customers which will lead to lower gross profit margins and vice versa.
- Efficiency in production
When a business organisation can achieve maximum efficiency in their production, they can reduce their costs as well as remove wastage at every stage of production. This leads to a higher GPM for the company.
- Product mix
A business having diverse streams can see an impact on its overall gross profit margin when one or more of its business divisions have a lower or consistently reducing margins.
- Macroeconomic conditions
Macroeconomic conditions have a direct impact on the gross profit margin of a business. In a booming economy, this can be higher and vice versa.
Conclusion
Gross profit margin is one of the primary points of reference for potential investors and lenders to ascertain the profitability of a business organisation. There can also be cases when a business has a positive gross profit margin but a negative net profit margin. Such crucial information allows interested entities to understand the financial health of a business and its key concerns.
FAQs
No. A positive gross profit margin of a business solely cannot be viewed as a parameter for investment. Interested parties should review other key fundamentals like net profit margin, EPS, PE ratio, ROE, ROCE, etc.
The formula to calculate the gross profit margin is
Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue x 100
Some of the key limitations of gross profit margin include the lack of its ability to account for all expenses, no accounting for price or volume alterations as well as timing of cash flows, no standard measure of the efficiency of business operations, etc.
Several users of gross profit margin include investors, creditors, regulators, management, and industry analysts.
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