Gross Profit Margin: Definition, Using, Formula, Example, And Explanation

Definition of Gross Profit

Gross profit is the profits after the deduction of the Cost of Good Sold from Revenues or Sales Revenues for a specific period. It is the entity’s profit after the conclusion of the cost of goods or services. Gross profit is reported in the income statement of the entity and it is used to assess the profitability of the entity as well as cost control.

Two important things could affect the amount of Gross Profit of the same entity in the same period. The first one is the revenue recognition policies. Different jurisdictions might use different accounting policies for revenue. For example, cash basis and accrual basis. If these two bases are used, the revenues will result differently.

Different Accounting policies used to measure the ending value of inventories also affect the cost of goods sold during the period.

For example, the value of inventories at the end of the period valued by FIFO might be different from the value measures by weight average cost. As a result, the cost of goods sold will be different and make so Gross Profit.

Here is the example of the Gross Profit Formula:

Sales Revenue $XXXX

Cost of Goods Sold ($XXXX)

Gross Profit $XXXXX

Gross Profit Formula is Sales Revenue – Cost of Goods Sold

As you can see in the above example, to calculate Gross Profit, you need to know Sales Revenues for the specific period and their Cost of Goods Sold.

Gross Profit Margin:

Gross Profit Margin is the proportion of Gross Profit over Sale Revenue for a specific period of time.  The margin is normally shown in percentage when we perform calculations because it helps us to interpret easily.

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Gross Profit Margin is very important as it is the indicator and measurement of how the entity controls its costs. If the margin is lower than the target or entity’s competitors, then it is said that the entity has poor cost control.

Subsequently, the entity might look at the design stage and figure out if there is an opportunity that costs could be reduced while the quality is still at the acceptable level.

Here is Gross Profit Margin Formula and how it is calculated,

The calculation of Gross Profit Margin equal Gross Profit / Sales Revenue

Let’s see the following example to help you figure out how the profit margin is.

Example: ABC is operating in retail products. For 01 January 2016 to 31 December 2016, ABC has the following transactions.

Sales Revenue $50,000,000

Cost of Goods Sold $10,000,000

Calculate the Profit Margin of ABC for 01 January 2016 to 31 December 2016?

Answer:

  • Gross Profit  = Sale Revenue –  Cost of Goods Sold = $40,000,000 ($50,000,000 – $10,000,000)
  • Gross Profit Margin = Gross Profit / Sales Revenue = $40,000,000 / $50,000,000 = 0.8 or 80%

As you can see, based on the above calculation, ABC got an 80% margin on its Sales. This margin is quite good yet, to make a better assessment, we need to compare this margin to our expectation or benchmark it again the competitors in the market.

After comparison, we could establish whether the current costing system is acceptable or not.

For example, if the margin is lower than its competitor, ABC might purchase the products at a high cost than its competitor; therefore, ABC needs to see if there are any other suppliers in the market that ABC need to approach or probably it needs to negotiate with the existing suppliers about the prices.

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In this example, ABC is not the manufacturing company, but if it were, then ABC has to look into the costing system. Reviewing the costing system might be starting from the design stage until the final production process.

For the design stage, ABC might need to review any component that needs to be removed or redesigned.

The production stages need to check if the production process is running correctly and efficiently. If not, the process monitoring or process redesign needs to be considered.

Gross Profit Ratio:

Profit Margin and Profit Ratio are the same things. As we can see from the about example, Gross Profit Margin of Gross Profit Ratio of ABC at the period ended 01 January 2016 to 31 December 2016 is 0.8 or 80%.

Gross Profit VS Net Profit:

Well, I am not going to talk about what is different, but I am going to talk about why it is different and the main objective of these two profit calculations.

These two figures have their own objective and use for different assessments. For Gross Profit Margin, we use it to assess the direct cost of products.

The cost could be the cost of purchasing the final product for reselling or the cost of production, including direct labor, direct overhead, and direct material.

If the margin is lower than expected or competitors, actions should be taken. If the margin is higher than competitors or expectations, that means the production system is good, and the company needs to maintain it.

In order words, the company has competitive advantages over its competitors.

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On the other hand, Net Profit Margin does not use to assess the production cost of the company, yet it’s used to assess the operating expenses in the company.

Those operating expenses include transportation, commission, sale and marketing expenses, and other operating expenses that are not related to the production cost.

These expenses need to be carefully controlled and reviewed by the company’s management. If the Net margin is low, the operating expense might be overspending. Then, the line-by-line analysis and review need to be taken.