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Gross Profit Margin

Gross Profit Margin

Gross profit margin is the measure of each pound of revenue left after paying cost of goods sold (COGS). Gross profit margin is also referred as ‘gross margin’ and is computed by dividing gross profit of a company by revenue earned during a financial year. It is calculated as:

Gross Profit Margin = ((Revenue – COGS)/Revenue) * 100, where, COGS is equivalent to Cost of Goods Sold

To understand it better, let’s take an example. Assume a company makes mobile chargers and reported a total revenue of £6.0 million in FY2016/17. For the same period, COGS (cost of direct labour and materials) was equivalent to £4.0 million. Hence, the company’s gross profit margin is equivalent to:

Gross Profit Margin = ((£6mn-£4mn)/£6mn) * 100 = 33.3%

This means the mobile charger manufacturing company has 33.3% of revenue left after making payment for direct cost expenses associated with the manufacturing of mobile chargers. Gross profit, which is equivalent to £2.0 million represents the amount which the company can use for operating expenses, taxes , interest, dividend pay-out etc. Gross profit margin is a profitability measure used by industry analysts and investors to relate similar companies (competitors) to the overall industry. It measures the feasibility and financial success of a specific product or service – higher the percentage the extra bucks a company saves to meet other costs and obligations. The margin percentage can be used by analysts or in-house experts to study the business condition by equating it with prior years’ margin (analysts can compare them with the margin of other companies in the industry). A regular enhancement in gross profit margin over the prior years is a signal of incessant improvement. It is accustomed to carefully track the gross profit percentage as a decline can be a signal to any of the following problems:

  • An increase in bad debts
  • A decline in prices
  • An increase in production costs
  • A change in the products or services sold
  • An increase in charges for antediluvian inventory
  • A change in the production process

Steps of computation

The gross profit margin percentage expresses profit as a percentage of the total revenue generated by an organisation or company. This percentage enables the in-house financial team to evaluate the profit of business. Since, diverse industries have dissimilar norms, it becomes difficult to compare gross profit margin between organisations in different sectors. The computation steps are as follows:

  • Deduct the total COGS from revenue generate by sales of goods or services to find gross profit. For example, if a business purchased goods worth £25,000 and sold them for £28,800, hence, the profit is £3,800 (£25,000 subtract from £28,800)
  • Divide the gross profit (£3,800 in this case) by total revenue generated £28,800 to get 0.132
  • Now, multiply the value from Step 2 by 100 (0.132*100 = 13.2%) to arrive at the gross profit margin percentage

Additionally, if an organisation or company sells goods, then the gross margin percentage is calculated as:

(Revenue - (direct labour + direct materials + Factory overhead)) ÷ Revenue

Here, direct labour is computed by adding salary, benefits, bonus, and payroll taxes of the entire workforce involved in manufacturing the products; direct materials include raw materials, and other components purchased to manufacture the desired product. Other expenses such as equipment, rent, factory supplies, and rent as included under the head Factory overhead

On the other hand, if an organisation or company sells services, then the gross margin percentage is calculated as:

(Revenue - (wages of employees + associated payroll costs of employees)) ÷ Revenue

Income statement and Gross Profit

An income statement or a profit and loss (P&L) statement reflects the revenue and expenses of an organisation or company during a financial period. Balance sheet, cash flow statement, and an income statement form part of the three financial statements. Below mentioned is an example of an income statement highlighting the Gross Profit computation:

Revenue FY2017
Gross sales 181,683
(Less sales returns and allowances) (10,000)
Net Sales 171,683
Cost of Goods Sold
Beginning inventory
Goods purchased or manufactured 130,028
Total Goods Available 130,028
(Less ending inventory)
Cost of Goods Sold 130,028
Gross Profit (Loss)
Expenses
Advertising
Bad debt
Commissions
Depreciation 16,616
Employee benefits
Furniture and equipment
Insurance
Maintenance and repairs
Office supplies
Payroll taxes
Rent
Research and development
Salaries and wages
Software
Travel
Utilities
Web hosting and domains
Other 16,192
Total Operating Expenses 32,808
Operating Income (Loss) 8,847
Non-operating revenues, expenses, gains, losses 12,762
(Less interest expense) (6,113)
Income Before Taxes 15,496
(Less income tax expense) (1,069)
Below-the-Line Items
Income from discontinued operations
Extraordinary items
Cumulative effect of accounting changes
Net Incom 14,427

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