Definition of Gross Profit Margin
Gross profit margin, also called the gross profit to sales revenue ratio, is a simple ratio that indicates a company, or organization's, profitability. It is calculated by dividing the profits accrued by a company (after taxes) by the number of sales made. Simply put, the gross profit margin is the markup on goods sold by a company.
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Calculation of Gross Profit Margin
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The gross profit margin is calculated by dividing the gross profit by sales and multiplying the result by 100. The value is commonly expressed as a percentage.
Its formula is:
Gross profit margin = Gross profit / Sales x 100
Dependence
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The gross profit margin depends largely on the type of business activities, or industry, a company is engaged in. A business in the service sector, for instance, commonly has no or marginal cost of goods sold. An example of such a business would be a laundry service or an institution that provides financial services.
On the other hand, it is not uncommon for a retailing, wholesale or manufacturing company to report gross profit margins that vary from 20 to 40 percent, due to a large cost of goods sold.
Gross profit margin of a company also depends on the number of its competitors in the industry as well as the emphasis it lays on research. Pharmaceutical and semiconductor manufacturing companies, for instance, have high gross profit margins due to their research-intensive nature.
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Factors that Increase Gross Profit Margin
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The gross profit margin of a product is directly related to its associated features and additional services, such as extended warranties and free-service or repair on damaged parts provided by a company. It also depends on the ability of the sales force to convince customers of the value-added services provided by the company.
Factors that Decrease Gross Profit Margin
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Factors that cause gross profit margin to decline include a reduction in selling prices (due to increasing competition); the cost of buying inventory is greater than the selling price of a manufactured good; and theft.
Importance
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According to Frank Vickers in the book “The Dynamic Small Business Manager,” the gross profit margin of a company allows the management and directors of a company to measure the amount customers are willing to pay for a product. It allows them to determine how much customers are willing to pay above the company's cost for that product.
The gross profit margin, according to Henry Lunt in the book “CIMA Learning System Fundamentals of Financial Accounting,” measures the effectiveness of the sales force, purchasing methods of an organization, pricing policies, and the effectiveness of manufacturing and production processes. It is used in cost control, to predict profitability levels, and to ascertain the accuracy of accounting systems by IRS and external auditors.
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References
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