What’s it: Gross profit margin or gross margin is a financial ratio to measure a company’s profitability, calculated by dividing gross profit by revenue. We get gross profit by subtracting the cost of goods sold from revenue.
Gross profit margin shows how much revenue is left after the company covers the direct costs associated with producing the goods sold, expressed as a percentage. We can use it as an indicator to measure production efficiency.
A higher margin is more desirable, indicating more dollars left to cover other costs, both operating and non-operating costs. Conversely, a low margin is less preferable because fewer dollars are available.
However, the ideal margin varies across industries, influenced by external factors such as the competitive landscape. In addition, competitive strategy and pricing also affect it. Another factor is operating efficiency.
Why is gross profit margin important?
Management checks gross profit margins to evaluate how efficiently the company is producing. They expect it to increase, or at least stabilize over time, which indicates they have succeeded in increasing or maintaining existing production efficiencies.
On the other hand, if the margin is decreasing, it could signal trouble. For example, the decrease in margin could be due to an increase in input prices such as raw materials and labor. Or, it may be caused by competitive pressures, which force companies to lower their selling prices. As a result, they can no longer maintain the high margins to remain competitive in the market.
Another reason gross margin is important is related to a company’s dollars to book. It affects how much volume must be sold to achieve the targeted profitability. For example, a company with a low margin must sell more goods to make more money. And, if it sells only a small volume, the company will find it difficult to cover other expenses such as marketing, general and administrative expenses, and interest expenses.
In contrast, companies with a higher margin need less volume to break even. This is because they have more dollars left for each unit sold, which they can use to pay for other expenses.
Long story short, companies must book a fairly high gross profit margin. Otherwise, their business is not viable, and they will find it difficult to survive in the long term.
How to calculate gross profit margin?
Calculating gross profit margin requires us to take two inputs in the income statement: revenue and gross profit. If there is no gross profit, we can calculate it by subtracting the revenue from the cost of goods sold (COGS). After getting it, we divide gross profit by revenue to calculate the margin. Here is the gross profit margin formula:
- Gross profit margin = Gross profit / Revenue
- Gross profit margin = (Revenue – COGS) / Revenue
For example, a company posted revenue of $4 million and a cost of goods sold of $3 million. From this data, the gross profit margin equals 25% = ($4 million – $3 million) / $4 million.
How to interpret gross profit margin?
What is the ideal gross profit margin? It varies between companies. In general, a higher margin indicates better profitability. It is preferred because more dollars are left from the sale. The company can then use it to cover operating and non-operating expenses such as interest expenses.
Look again at the example above. The company leaves a quarter (25% worth $1 million) of its revenue as profit. So, if the percentage is lower, fewer dollars are left. And for this reason, a low margin is less preferable.
What are the factors influencing the gross profit margin?
Several factors affect the gross profit margin. Apart from depending on the company’s industry, external factors such as competition also affect reported profits beyond management’s control. Other factors are competitive strategy, adopted pricing, technology, and production management.
Normal margins will differ between industries. Some have higher margins. But not with the others.
For example, companies in the food industry tend to have lower margins than those operating as consultants. This is because food companies must account for higher upfront costs for equipment and raw materials. On the other hand, consulting firms will not have much to spend when providing services.
Intense competition squeezes profit margins. It is difficult for a company to charge a higher price than competitors without causing its customers to switch to competitors.
A fairly obvious case is when a price war arises in the market. Players compete with each other to lower prices to attract more customers. As a result, market prices continue to fall. It ends up squeezing their profit margins because it doesn’t come with an adequate reduction in costs.
According to Porter, there are two alternative competitive strategies to gain competitive advantage: differentiation and cost leadership. Both have an impact on the profit margin obtained.
A differentiation strategy generates a higher margin than a price leadership strategy. Under a differentiation strategy, the company emphasizes uniqueness to encourage consumers to be willing to buy at a premium price. In contrast, cost leadership strategies emphasize cost structure savings and charge prices on the industry average.
Pricing strategies also affect the gross profit margin. That impacts how much revenue is earned relative to the costs incurred.
Take penetration pricing as an example. Companies sell their products at low prices to attract demand. Thus, they record a low margin.
The penetration pricing strategy is generally adopted by new players in the industry, which do not yet have a customer base. They sell their products at low prices to attract more consumers to buy. Once they have a sizable customer base, they then slowly increase their prices and, therefore, improve their gross profit margins.
What to read next
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- Return on Invested Capital (ROIC): Calculation and Interpretation