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 = $10,000 = $50,000
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
Gross Profit Margin = $265 * 100
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.
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).
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:
– 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 $ZZZ,ZZZ
Adjusted Gross Sales ZZZ,ZZZ
– Discounts ($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%
Adjusted Gross Sales 1,021,541 21.39%
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:
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%
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%
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
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.
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.
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 Margin
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.