Gross Profit Margin (GPM) is ratio between Gross Profit and Sales Revenue. It compares Gross Profit with Sales Revenue.
What does Gross Profit Margin (GPM) measure?
Gross Profit Margin (GPM) shows Gross Profit as a percentage of Sales Revenue. This ratio tells us how much Gross Profit is earned from USD$1 of Sales Revenue.
Gross Profit Margin (GPM) measures how well the business adds value to the cost of production. It is a good indicator of how effectively managers control the cost of production Cost of Goods Sold (COGS).
Any improvement in Gross Profit Margin (GPM) from one year to the next indicates higher added value for products and lower cost of production.
How to calculate Gross Profit Margin (GPM)?
The figures for working out Gross Profit Margin (GPM) can be found in Profit and Loss Account (P&L Account):
| Gross Profit | |||
| Gross Profit Margin (GPM) = | ━━━━━━━━━━━━ | x 100 | |
| Sales Revenue |
Comment
Gross Profit Margin (GPM) is expressed as a percentage.
If a business has Sales Revenue of USD$1,000,000 and Gross Profit of USD$600,000, then Gross Profit Margin (GPM) is 60%. If Gross Profit Margin (GPM) is 60%, it means that for every USD$100 of Sales Revenue USD$60 is Gross Profit and USD$40 is the cost of production Cost of Goods Sold (COGS). So, the cost of production accounts for 40% of Sales Revenue. The USD$60 of Gross Profit will go towards paying Expenses (Overheads).
Gross Profit Margin (GPM) will be different for different industries. The higher the Gross Profit Margin (GPM) the better – the company better controls its costs of production.
Commonly, high volume products with quick turnover of inventories such as confectionary, FMCG and fast food will have relatively low Gross Profit Margin (GPM). The high sales volume will compensate for lower margins. Low volume products with slow turnover of inventories such as car dealerships, jewelry stores, insurance providers, aircraft manufacturers, luxury wines producers will have relatively high Gross Profit Margin (GPM). The high margins volume will compensate for lower low sales volume.
Gross Profit Margin (GPM) measures how well the business adds value the firm’s cost of production. Add, how well the business’s managers control the cost of production.
Example for Gross Profit Margin (GPM)
COMPANY A
Company A has Sales Revenue of USD$1,000,000, Cost of Goods Sold (COGS) of USD$700,000 and Gross Profit of USD$300,000 in 2020. One year later in 2021, Company A has Sales Revenue of USD$1,500,000, Cost of Goods Sold (COGS) of USD$600,000 and Gross Profit of USD$900,000. The following shows Gross Profit Margin (GPM) for Company A in 2020 and 2021.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Sales Revenue | $1,000,000 | $1,500,000 | |||||
| Cost of Goods Sold (COGS) | $700,000 | $600,000 | |||||
| Gross Profit | $300,000 | $900,000 | |||||
| Gross Profit Margin (GPM) | 30% | ➚ | 60% |
What happened? Gross Profit Margin (GPM) in 2020 was 30%. The result tells us that every USD$1 of sales revenue earned USD$0.3 of Gross Profit in 2020. The cost of production Cost of Goods Sold (COGS) was USD$0.7. However, in 2021, Gross Profit Margin (GPM) increased from 30% to 60%. The result tells us that every USD$1 of sales revenue earned USD$0.6 of Gross Profit in 2021. The cost of production Cost of Goods Sold (COGS) was USD$0.4.
Why it happened? It happened because Sales Revenue increased from $1,000,000 in 2020 to $1,500,000 in 2021 as well as the cost of production Cost of Goods Sold (COGS) decreased from $700,000 in 2020 to $600,000. This caused Gross Profit to increase from $300,000 in 2020 to $900,000 in 2021.
What does the change mean? Company A’s Gross Profit Margin (GPM) is higher as the company managed to increase its revenue while at the same time lowering the cost of production having lower cost of sales. This could be the result of lower direct material costs, using cheaper suppliers or lower direct labour costs in 2021 comparing with 2020. The management of Company A was more effective in controlling production costs.
Is it good or bad for the business? This is good for Company A as it now has higher Gross Profit towards paying Expenses (Overheads). A comparison of results indicates that the profitability of Company A was improving.
COMPANY B
Company B has Sales Revenue of USD$1,000,000, Cost of Goods Sold (COGS) of USD$700,000 and Gross Profit of USD$300,000 in 2020. One year later in 2021, Company B has Sales Revenue of USD$900,000, Cost of Goods Sold (COGS) of USD$720,000 and Gross Profit of USD$180,000. The following shows Gross Profit Margin (GPM) for Company B in 2020 and 2021.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Sales Revenue | $1,000,000 | $900,000 | |||||
| Cost of Goods Sold (COGS) | $700,000 | $720,000 | |||||
| Gross Profit | $300,000 | $180,000 | |||||
| Gross Profit Margin (GPM) | 30% | ➘ | 20% |
What happened? Gross Profit Margin (GPM) in 2020 was 30%. The result tells us that every USD$1 of sales revenue earned USD$0.3 of Gross Profit in 2020. The cost of production Cost of Goods Sold (COGS) was USD$0.7. However, in 2021, Gross Profit Margin (GPM) decreased from 30% to 20%. The result tells us that every USD$1 of sales revenue earned USD$0.2 of Gross Profit in 2021. The cost of production Cost of Goods Sold (COGS) was USD$0.8.
Why it happened? It happened because Sales Revenue decreased from $1,000,000 in 2020 to $900,000 in 2021 as well as the cost of production Cost of Goods Sold (COGS) increased from $700,000 in 2020 to $720,000. This caused Gross Profit to decrease from $300,000 in 2020 to $180,000 in 2021.
What does the change mean? Company B’s Gross Profit Margin (GPM) is lower as the company managed to decrease its revenue while at the same time increasing the cost of production having higher cost of sales. This could be the result of higher direct material costs, using more expensive suppliers or higher direct labour costs in 2021 comparing with 2020. The management of Company B was less effective in controlling production costs.
Is it good or bad for the business? This is bad for Company B as it now has lower Gross Profit towards paying Expenses (Overheads). A comparison of results indicates that the profitability of Company B was worsening.
How to improve Gross Profit Margin (GPM)?
Gross Profit Margin (GPM) is influenced by both Sales Revenue and the cost of production Cost of Goods Sold (COGS). This means that a business can improve its Gross Profit Margin (GPM) by increasing Sales Revenue and decreasing the cost of production Cost of Goods Sold (COGS).
1. Increase Sales Revenue:
- Increase quantity sold. Simply selling more products by using appropriate marketing strategies. Managers can attract more customers to raise sales by making the marketing of a firm more effective. What are the possible marketing strategies?
- Using new promotion methods or changing current ineffective promotion methods;
- Product extension strategies preventing the product from entering the decline stage in Product Life Cycle;
- Innovating new products to enlarge Product Portfolio;
- Entering into new markets to find new customers;
- Targeting new market segments to sell to different types of customers;
- Repackaging to make the product more appealing to customers, however, this will raise the firm’s expenses.
- Using E-Commerce or other distribution channels to make the products available to customers in more places.
Managers can also grow the business by increasing its production and selling capacity through opening more shops, hiring more sales personnel, taking over another business, etc.
- Change the price. The business can either increase the price or decrease the price. Changing the price raises the value of each item sold, but may cause a fall in the volume of sales. How to make altering the price work to gain competitive advantage?
- Reduce the selling price of products. For elastic products managers should decrease the price to sell more. Also, for products which there are many substitutes on the market. Additionally, for products with poor brand loyalty.
- Raise the selling price of products. For inelastic products managers should increase the price to boost Sales Revenue. Also, for products which there are few substitutes on the market, or for complementary products. Additionally, for products with strong brand loyalty.
Ideally, raising the price of the product should be done with no significant increase in Variable Costs (VC). Also, changing the price may damage the long-term image of the business.
- Seek alternative revenue streams. While the most common revenue stream for many businesses is from selling products to individual customers and other businesses, there are many other non-operating revenue streams that the business ought to explore such as advertising revenue, subscription revenue, merchandise revenue, renting or leasing assets, etc. This will boost sales revenue for non-core business activities, particularly when affected by seasonal demand.
2. Decrease cost of production Cost of Goods Sold (COGS):
- Cut direct material costs:
- Use cheaper raw materials. Use replacements which look similar and have similar function, but are much cheaper to find. For example, use artificial leather instead of real leather to make shoes while charging the same prices. Some furniture producers are using particle boards instead of real wood to manufacture tables and cabinets. However, this may negatively impact the perceived product quality.
- Use less raw materials. Use less raw materials to make products. For example, offer smaller size hamburgers in the restaurant while charging the same prices as for bigger ones sold previously. Some airlines have saved millions of dollars each year by cutting back on the amount of chocolates or snacks that they offer on-board. However, this may negatively impact customer satisfaction.
- Find new cheaper suppliers. Change suppliers and buy from those who offer lower prices of raw materials. However, this can hinder the quality of final products.
- Lower packaging costs. Instead of using two or three different types of wrappers to package the product, the production department can replace excessive packaging with only one layer. Alternatively, the firm may ask some of its customers to come and pick up the products in person which will eliminate the need for any packaging to be used. This will allow the business to reduce packaging costs to zero.
- Cut direct labour costs:
- Reduce number of workers. Lowering staffing costs can be achieved by cutting the number of staff and getting remaining staff to do more for the same pay. However, this method can cause resentment and demotivation.
- Reduce workers’ pay. Lowering staffing costs can be achieved by cutting wages for production workers per piece produced or per hour. However, this method can cause motivation levels to fall reducing productivity and quality.
- Relocate production to countries with cheaper labor. Lowering staffing costs can be achieved by relocating production to low-labor-cost countries such as India, Vietnam, Indonesia, etc. However, this method can put quality at risk while communication problems with distant factories may also emerge.
- Use automation. Managers can seek more cost-effective production methods such as producing many products in one batch rather than making each product individually. By using assembly lines to mass produce products firms can lower Average Variable Cost (AVC), thereby helping to raise Contribution Per Unit made from selling each unit of output. While robots are very labor-saving, purchasing machinery will increase Expenses (Overheads) and workers need to be retrained to operate those new machines.
