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Gross Profit Margin

The difference between the sales price and the cost of the product or service rendered is known as gross profit margin in business.  It is traditionally the amount identified on the income statement or a tax return as the amount earned after cost of sales a.k.a cost of goods sold, cost of services rendered, etc. is subtracted from sales (revenue).

Sophisticated entrepreneurs realize there is more to this value than simply stating sales less cost of sales.  This is because each industry from all the various sectors define both sales and cost of sales differently.  Many small business retail stores will define cost of sales as the cost of the item sold.  Whereas Wal-Mart will define cost as everything from distribution costs, storage, product cost, store labor and store operations in their definition of cost of goods sold.  Wal-Mart’s gross profit margin might run 19% whereas the small business retail store may have 60% profit margins.

One of the most common uses of the gross profit margin in reading reports is as a ratio in business.  It is used as the percentage of sales in the in the contribution margin to offset operational expenses.  As an example, if your business has $10,000 of operational expenses per month and the sales margin is 20%, how much in sales per month is necessary to cover these operational expenses?  The formula is:

     Sales Needed = Operational Expenses
Gross Profit Margin

Sales Needed = $10,000   = $50,000
                               20%

Some businesses call this the breakeven point of the operation.

But the most important business attribute of the gross profit margin is its application in business analysis.  Highly experienced and knowledgeable industry experts use it as a tool to evaluate opportunities such as synergy, mergers, buyouts and leverage.  These more advanced business models are what separates good business and unbounded success.

This article educates the reader in the fundamentals of gross profit margin and its application in small business.  It continues by elaborating on its use as a ratio and the importance of consistency with its use.  It also goes into the reporting format that is most beneficial to small business.  Finally this article touches base on how the gross profit margin is used to add new departments or product lines to a business.  This final section illustrates its use in buying additional capacity in small business by leveraging the gross profit margin and adding to the bottom line.

Overall this lesson explains to the novice businessman the term ‘Gross Profit Margin’ and how to properly apply the formula in small business.  In preparation for this lesson, the reader may want to review the following:

        A) Gross, Operational and Net Profit           C) Business Ratios
        B) EBITDA                                                      D) Gross and Net Sales 

Gross Profit Margin Fundamentals

In accounting, gross profit is defined as sales minus cost of the items sold.  Gross profit is always stated in dollars.  Margin is stated as a percentage.  It is equal to the dollar value of the gross profit divided by sales in dollars multiplied by 100.  Look at the following illustration:

  Sales                =  $590
  Cost of Sales    =   325
  Gross Profit      =  $265

  Gross Profit Margin  =   Gross Profit    * 100
                                         Sales 

  Gross Profit Margin  =  $265   * 100
                                        $590

  Gross Profit Margin  =  .449 * 100 = 44.9%

The average individual will tell you that a fair profit margin is 50%.  Yet at the same time will try to haggle a car from a dealer for cost.  The idea behind a fair and reasonable profit margin is to pay for administrative costs and make a fair net profit.  Without a fair net profit, the business will not stay in business for the consumer.  So profit is an exchange of value for longevity for future service and availability. 

In reality, each industry has different profit margins in order to cover administration expenses, costs of capital  and end up with a net profit.  Here is the typical outline of the income statement for reference.

                                                 ACME                           . 
                 Income Statement (Profit and Loss Statement)
For the Period Ending Month, Day, Year          .

  Sales                                                              $ZZZ,ZZZ
Cost of Sales                                                     ZZZ,ZZZ
Gross Profit                                                       ZZ,ZZZ
Expenses (Administration)                                    Z,ZZZ
Operational Profit                                                ZZ,ZZZ
Capital Expenses                                                    Z,ZZZ
Net Profit                                                              $Z,ZZZ 

Remember, the margin equals gross profit divided by sales time 100.

Cost of Sales

As cost for sales increases, gross profit decreases and so does the margin.  So the primary driver of gross profit margin is defining costs.  Costs are different in each industry.  Here are several variances of costs.

* Food Service Industry  – The food service industry uses the term ‘Prime Costs’ to substitute for cost of meals served.  Prime costs customarily include food and labor (chefs, waiters, hostess, dishwashing staff) to serve the customer.   In addition, well managed operations include supplies (napkins, condiments, spices, cutlery, & tablecloths); hygiene such as cleaning agents and linen service; dining facility maintenance and cleaning, and labor taxes/benefits in its definition of costs of meals served.

* Construction Industry  – This industry has two cost groups.  Direct costs include materials, labor, subcontractors, permits and other for the project.  An indirect group associates costs for several projects due to sharing of these costs.  These include management salaries/benefits, transportation, insurance, communications and tooling.

* Hauling Industry – The biggest unknown in this industry is the cost of fuel.  Other costs include driver wages, legal compliance; truck maintenance and repairs, and truck depreciation.

In small business, the most common error is identifying true costs associated with a sale.  Most rookie entrepreneurs do not identify all the costs directly assignable to sales.  An example of an error is the exclusion of certain employees within the labor force like the distribution or warehouse labor assigned to administration costs.  To rely on the gross profit and the corresponding margin it is essential to separate administrative costs and cost of sales.  For accountants the key trigger in separating these expenses is based on:  ‘Without this costs, could the company complete the sale?’  If the answer is ‘Yes’ the cost is administrative.

As an example, the rag used by the mechanic to clean his hands of grease before grasping the steering wheel of the customer’s car; is this cost of sales or an administrative cost?  Answer:  If the customer finds grease on his steering wheel, he’ll demand his money back.  Is there a sale once the refund is issued due to sloppy work?  The rag and the cleaning of the rag are cost of sales (in this case services rendered).

Sales

A second fundamental of determining gross profit margin is defining sales.  The average  person will tell you it equals the amount rung up at the cash register.  In reality, it is a much broader definition.  For one thing customers often return products.  So sales should be adjusted for returns.  Also, customers are granted allowances to either maintain the relationship or eliminate a return.  Another adjustment involves what is commonly referred to as discounts; this includes incentives such as coupons, bulk buys and other forms of sale price adjustments (BOGO’s, cash payment, buy before a certain time frame, etc.).  So a typical sales section of the income statement may look like this:

  Sales
    Retail                                               $ZZZ,ZZZ
    Adjustments:
       – Discounts                 ($Z,ZZZ)
       – Returns                      (Z,ZZZ)
       – Allowances              (ZZ,ZZZ)
    Sub-Total Adjustments                       (ZZ,ZZZ)
   Net Sales                                           $ZZZ,ZZZ 

The gross profit margin is based on the relationship of gross profit to net sales and not total sales as identified in the retail line.   It is a more accurate accounting value as to gross profit margin.

Another common variable in calculating gross margin is franchise fees.  Royalties paid a franchisor is always identified as a revenue sharing function in the franchise agreement.  Therefore it is a sales adjustment.  It is reported as follows:

   Gross Sales                                        $ZZZ,ZZZ
   Royalties                                              (ZZ,ZZZ)
   Adjusted Gross Sales                          ZZZ,ZZZ
   Adjustments:
      – Discounts                   ($Z,ZZZ)
      – Returns                        (Z,ZZZ)
      – Allowances                (ZZ,ZZZ)
      Sub-Total Adjustments                     (ZZ,ZZZ)
   Net Sales                                           $ZZZ,ZZZ 

Note how sales is restated as gross adjusted sales; the co-sharing of revenue is subtracted to get adjusted sales.  As before, the gross profit margin is calculated against net sales.  To illustrate the importance of this principle, compare the gross profit margin between gross sales, adjusted gross sales and net sales for a simple Subway franchise sales and cost of meals served section of an income statement.

                             SUBWAY STORE # ZZ,ZZZ
                      Income Statement (Limited Scope Report)
                        For the Year Ending December 31, 2015

                                                  Results           Gross Profit Margin
   Gross Sales                        $1,108,202                  19.71%
   Royalties                                 (86,661)
   Adjusted Gross Sales          1,021,541                   21.39%
   Adjustments                            (39,657)
   Net Sales                                981,884                    22.25%
   Cost of Meals Served             763,402
   Gross Profit                          $218,482 

The correct gross profit margin is 22.25%.  The gross profit is related against net sales and not the greater values of adjusted or gross sales.  If the formula includes the higher dollar values then the margin percentage decreases.  Under actuarial principles this has a significant impact when using millions of dollars.

Now that the reader understands the formula principles, it is time to explain the gross profit margin as a ratio and the importance of consistency with its application.

Gross Profit Margin Ratio and Consistency

Once a small business has established the correct formula for sales and costs the ratio can now be used for multiple purposes.  For the reader a key business principle is called markup.  Markup has a direct relationship to margin.  Here are the two relational definitions:

  Margin is the percentage of profit on sales.
  Markup is the percentage added to cost to calculate the sales price.

Remember, gross profit is sales less costs.  Using the earlier example of a gross profit margin, let’s calculate markup.

  Sales              = $590
  Costs             =  325
  Gross Profit  = $265   Gross Profit Margin = 44.9%

  Markup = Gross Profit divided by Costs times 100 

  Markup         = $265   = 81.53%
                           $325

So, given this information, a store wants to be consistent and wants to sell a product costing $409.  What is the sale price?

  Sales Price  = Cost plus Dollar Markup
  Sales Price  = Cost plus (Cost times Markup Percentage)
  Sales Price  = $409 plus ($409 * 81.53%)
  Sales Price  = $409 + $333
  Sales Price  = $742

Will the gross profit margin remain the same at 44.9%?  Let’s find out.

  Sales              = $742
  Costs             =    409
  Gross Profit   =  $333 

  Gross Profit Margin = Gross Profit  times 100  =  $333  * 100  =  44.9%
                                       Sales                                   $742

So one of the uses of the gross profit margin is to calculate markup on new items for sale or on existing goods if the cost of vendor supplied goods change.  This happens frequently in business, with some businesses, daily.  Another purpose of the gross profit margin as a ratio is its use as a standard, i.e. a consistent point of reference.  Over time businesses settle in to a regular level of administrative and capitalization cost of doing business.  The gross profit margin serves as the breakeven point value to service the overhead and generate a desired profit.

Eventually management learns that the key to success is to consistently raise the profit margin to cover the overhead or sometimes referred to as fixed costs [link to article – Fixed Costs].  The cost of sales are similar to variable costs.   To achieve this, management tinkers with variable costs (use substitutes, negotiates volume discounts, faster production) in hopes of lowering overall variable costs and raising the gross profit margin.   An alternative is to raise the selling price without a reduction in sales volume.   Any marginal increase in gross profit margin can make a significant difference to the bottom line.

Below is an example of a used car dealership analyzing options with the gross margin.  The dealership’s monthly overhead and desired profit is $35,000.  The regular gross profit margin is 18%.  The sales team currently closes 37 deals per month.  The average sales price per unit is $5,255.  The team believes that a 16% margin will increase the number of deals per month to 41 units.  Can the dealership cover overhead and profit by reducing the sales price to generate a 16% margin?   Markup at a 16% margin equates to a sales price of $5,130 per unit.

                      NEWSOME USED AUTOS
         Breakeven Analysis – Monthly Required Sales

                             Current Margin       Modified
                                     18%                      16% 
Sales                          $194,444          $210,330  41 units @$5,130/ea
Cost of Cars                 159,444           176,669   (cost per unit equals $4,309)
Gross Profit                  $35,000           $33,661
Overhead & Profit        $35,000           $35,000

At 16% gross profit margin and with four additional units sold, the dealership will fall short of the necessary minimum needed by $1,339.  Sales would need to increase to 43 units per month to make this option viable.

In the above example the gross profit margin serves as a focal point in evaluating breakeven points, economies of scale and overall financial performance.  In business, it is the hub of the entire financial wheel.

For an owner, find the gross profit necessary to cover overhead and desired profit.  From here determine sales volume and contribution margin per unit of sales.  Both volume and cost of sales will naturally be revealed and then monitor the results.  Look for consistent improvement from one interim period to the next.  If improvement is consistent, success is a matter of time.  Once success is achieved, owners can use the gross profit margin to evaluate growth.

Gross Profit Margin and Growth

An advanced use of the gross profit margin is its value in expanding business operations.   From adding products for sale to full scale mergers, the gross profit margin is instrumental in evaluating potential net profit from the additional expansion.  For any additional products, management looks at two important variables to evaluate adding a new product.  One variable is the addition of any new administrative costs and the second variable is the gross profit needed to cover these additional variable costs.  To illustrate, let’s take a look at a small business adding an additional product line.

Camping World 

An RV dealership is considering adding a warranty program for trailers and fold-downs (commonly called pop-ups).  The warranty company requires an annual inspection of facilities and certification of the service department.  Annual administrative costs for compliance is $4,700.  There are no additional costs or burden on the existing administrative function for Camping World to add this product.

The cost of each warranty sold is $199.   The initial thought is to sell the warranty for $425.   This generates a $226 contribution margin [link to article – Contribution Margin] per warranty.   To cover administrative costs associated with this product, the dealership must sell 21 warranties per year ($4,700 divided by $226 contribution margin each).  This is around 2 warranties per month.  Any warranty sold over 21 units generates $226 additional net profit per warranty sold.

The dealership’s current gross profit margin is 17%.  In order to get a 17% margin on warranties the dealership would have to sell the warranties for $240 each.  At a gross contribution margin of $41 each the dealership will have to sell 115 warranties or 10 per month to cover administrative costs.   See the following schedule.

   Sales                                      $27,600    115 @ $240/each
Costs                                        22,885    115 @ $199/each
Gross Profit                             $4,715     17% Gross Margin
Administration Costs                4,700 
Net Profit                                     $15 

In this example, Camping World must sell between 21 and 115 warranties per year depending on the gross profit margin desired.   Naturally the low 17% margin is unrealistic so the real question is: ‘How many units can be sold in one year?’  The minimum margin of 17% requires a lot of salesmanship on behalf of the F&I (Finance and Insurance) manager, so it is more realistic to sell them at a higher gross profit margin.

One other note about this situation.  The higher gross profit margin will slightly increase the overall dealership margin due to the weighted average formula for gross profit margin.   Sometimes it is a good idea to have independent gross profit margins for each department, i.e. one for new RV sales, a separate one for used RV’s, others for parts, service and the F&I department.

Not only is the gross profit margin instrumental in evaluating adding new products or lines, it is also a crucial factor in full scale mergers.  Take a look at this case.

S and S Electrical 

Mark owns S and S Electrical.  His workload is off the charts and he can’t meet the demand.  He just doesn’t have enough qualified staff.  His current gross margin is 43% on $5.3 Million a year in sales.  His overhead is $2.1 Million a year.

A friend of his (Greg) owns an electrical service business and has fallen on hard times.  Greg wants to retire in two years and wants to sell his business.  He currently generates a 38% gross profit margin on $1.4 Million per year in sales.  His administrative costs are right at $550,000 per year.  Greg has three qualified electricians in his labor pool.  Greg approaches Mark about buying Greg’s business.  Assuming all other variables are optimum for Mark, what would Mark offer to pay Greg off in two years?

Mark assesses Greg’s portfolio of work and figures that 1/2 of Greg’s sales can be adjusted to Mark’s gross profit margin without the customer’s departing the portfolio.  The other half of value can be used in Mark’s existing operations and expand Mark’s current workload at 43% margin.   Mark determines that he can increase the current markup of Greg’s work to his markup and generate the additional margin.   Since the administrative costs will remain the same, any increase in dollars will simply add to the bottom line.  Whatever this value is times 2 years will be his offer to Greg.   Let’s do the math.

                          Greg’s Electrical                    Greg’s Electrical
                         Current Analysis                Modified to S&S Standard
 Sales                     $1,400,000                            $1,522,732
Costs                          868,000                                 868,000
Gross Profit                532,000   38%                      654,732   43%
Overhead                    550,000                                550,000
Profit (Loss)              ($18,000)                             $104,732
Markup                        61.3%                                  75.43%

Mark offers Greg $210,000 ($104,732 * 2) for his business to be paid over two years.  For Mark, this will cost him zero and after two years he’ll own an electrical company with $6.8 Million ($5.3 Million plus $1.5 Million) in sales per year.   It is a good deal for Mark and a good deal for Greg.

Caveat to the Above 

Valuation of a business is a complicated algorithm and is not as simple as illustrated above.  If interested in learning more go to the marginal value section of this website.

Summary

Gross profit is the difference between sales price and actual costs of the products/services sold.  Gross profit margin is the dollar value stated as a percentage of sales.

The fundamentals of the gross profit margin tie together sales, cost of sales and markup (value on top of costs).  In addition, this figure is used in evaluating breakeven points for overhead costs (administrative, capitalization and taxation) and of course, desired profit.  The real value of utilizing gross profit margin comes into play when evaluating financial performance from one interim period to the next and over an extended period of time.   Sophisticated entrepreneurs use it to evaluate adding new products or adding an entire department to the existing business structure.  Overall, it is the most important of all business ratios as it defines the ability to succeed.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article.

 

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About David J Hoare (420 Articles)
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns