Gross profit margin is a financial calculation that reveals a number of very things about the performance of your business. It uses figures from your Profit and Loss statement to determine how much money is left over after paying for the production and sale of the product(s).
You may, therefore, find it useful to familiarise your self with profit and loss statements and how they are generated before you proceed.
The profit and loss (P&L) account is a record of business performance over a specific period and provides 'snapshot summary of the total income and expenses for that period. This example Company alpha has produced the following profit and loss account for the first six months of its business:
Gross Profit is the difference between the sales that a business makes less the DIRECT COSTS of making the sales. Direct Costs are those costs that increase as the sales increase and decrease with the sales. Usually, this is stock used up in the sale as well as the packaging and deliveries. The more you sell the more stock is used up and the more you use on packaging and deliveries.
Over Heads are all the other costs that do not fluctuate (like rent or insurance, telephone, business rates etc) with sales are called overheads and are dealt with later.
In the example below Alpha Limited is a business that sells books by mail order. Their Direct Costs are:
- a) The stock used (can be found by subtracting the value of books left in the stock room from the total cost of purchases)
- b) The packaging and delivery of the goods
Both these expenses will fluctuate and change in relation to the sales made. The more sales, the higher the direct costs.
GROSS PROFIT MARGIN (OR RATIO) is the fraction of the gross profit divided by the sales and multiplied by 100.
In our example
This tells us that for every £1 earned by Alpha Ltd in 2018, 60p is left over for payment Overheads.
Functional Use of GPR
- GPR to compare performance over the period of time: Here we can look at GPR during different periods of time. In the example below, we see the profit and loss of Alpha Ltd in 2018 and 2019.
Calculating the GPR for both years we get
For every pound earned in 2018 the company kept generated 60p for overheads in 2018 but kept 66p in every pound in 2019. This could be due to a drop in one stock purchase price and/or packaging and delivery in 2019.
You can identify these variances by calculating the ratio of each expense Here you divide the cost by the sales.
Figure 4 shows the ratios in green
Possible deductions from this:
- The stock purchase price has dropped between 2018 and 2019 (could this be that larger stock purchases have introduced bulk discounts?
- There is a definite increase in delivery and packaging charges since 2018. If we had separated the figures for packaging and delivery, we would have been able to drill down a bit further and discovered the answer to this.
- Calculating a Break-Even analysis based on GPR.
Example, Alpha Ltd have forecasted a Overheads cost of £45,000 and want to estimate the amount of sales they would have to generate to break even (i.e. to sell enough to pay the £45000. Assuming that our GPR will not alter from 2019, we can predict the turnover required to break even.
Ratios like these should be used with caution as these will fluctuate to reflect the fluctuations in the marketplace. Here although we have estimated that Alpha Ltd needs to generate sales of £75,000 in 2019, we are assuming that all the direct costs will remain proportionately the same. However, there are many factors that may influence them to change.