Gross Profit Margin Ratio


Definition

Gross Profit Margin Ratio is the percentage of gross profit relative to the revenue earned during a period.

Gross Profit Margin Ratio is also known as Gross Margin Percentage and GP Margin Ratio.

Formula

Gross Profit Margin Ratio=Gross Profitx100%
Revenue

Where:

  • Gross Profit is equal to revenue minus cost of sales;
  • Revenue is the income earned from principal business activities.

Example

ABC PLC is in the business of manufacturing stationery supplies.

The financial results of ABC PLC for the year ended 30 June 20X4 are as follows:

$ Million
Income
Sales revenue from selling stationery100
Gain on disposal of investments10
Interest income on bank deposits20
130
Expenses
Production expenditure60
General and administrative expenses20
Taxation15
95
Profit for the year (Income Less Expenses)15

Gross Profit Margin Ratio will be calculated as follows:

Gross Profit %=Gross Profitx100%
Revenue
=Revenue - Cost of salesx100%
Revenue
=$100 - $60x100%
$100
=40%

Notes:

  • Gain on disposal of investments and interest income are not considered as revenue because they are not earned from the principal business activity of ABC PLC, i.e. selling stationery goods
  • Cost of sales includes only expenses that are directly associated with producing goods or rendering services and therefore does not include expenses such as general and administrative costs and tax expense.

Explanation

Gross Profit Margin Ratio shows the underlying profitability of an organization's core business activities.

A GP Margin of 40% suggests that every $1 of sale costs the business $0.6 in terms of production expenditure and generates $0.4 profit before accounting for any non-production costs. As a general rule, lower the GP margin ratio of a business, higher the sales volume that will be required to maintain the overall profitability and vice versa.

GP Margin Ratio can be influenced by internal as well as external factors.

Factors that can impact GP margin include:

  • Type of industry
  • Level of competition in industry
  • Extent of product differentiation
  • Cost structure of the organization
  • Economies of scale
  • Efficiency of operations
  • Cost of factors of production
  • Market demand
  • Product life cycle phases
  • Accounting policies

Analysis & Interpretation

The trend of GP Margin Ratio should be analyzed over several periods in the context of the norms of the industry segments the company operates in.

A change in GP Margin Ratio could be attributed to numerous factors in different scenarios as summarized in the below:

a) Increase in GP Margin Ratio & Decrease in Total Gross Profit

Possible Causes:

  • Increase in selling price not resulting in greater sales revenue due to price elastic demand of company products.
  • Decrease in production costs achieved in the later stages of product life cycle (e.g. through better manufacturing efficiency) offset by a lower demand.

b) Increase in GP Margin Ratio & Increase in Total Gross Profit

Possible Causes:

  • Increase in selling price of products with inelastic demand.
  • Increase in sales volume resulting in the decrease of production costs due to economies of scale.
  • Decrease in the level of competition (e.g. due to acquisition of rival companies) resulting in higher selling price, lower production costs (e.g. due to greater economies of scale and synergies) and improved market share.

c) Decrease in GP Margin Ratio & Increase in Total Gross Profit

Possible Causes:

  • Decrease in selling price resulting in greater sales revenue due to price elastic demand of the company products

d) Decrease in GP Margin Ratio & Decrease in Total Gross Profit

Possible Causes:

  • Increase in competition forcing a decrease in selling price and reduction in market share.
  • Lower market demand forcing a downward pressure on selling price.
  • The burden of increase in production costs not being transferred to customers through increased selling price.
  • Inefficient production.

A change in GP margin ratio could therefore be attributed to several factors as discussed above.

Generally, a higher gross profit margin is desirable as it suggests a greater potential for earning larger profits. Businesses with higher gross profit margins are better equipped against unanticipated increase in the cost of production or competition.

Businesses sometimes deliberately lower their GP margin to improve their overall profitability by lowering selling prices with the aim of increasing their market share in industries and market segments that are highly sensitive to price. It is important for such businesses however to operate highly efficiently in order to minimize their costs.

Industry Benchmarks

The performance of GP margin ratio of a company may be compared to other rival firms operating in similar industry segments.

Gross Profit Margin Ratio can vary drastically not only from industry to industry but also within different market segments of the same industry.

Average GP Margin could be used to compare profitability but such averages could be distorted on account of variations in the profitability margins of different market segments within that industry.

When benchmarking the GP Margin performance, it is therefore preferable to select companies that target similar market segments within that industry.

Limitations

Obtaining discrete financial data relating to the gross profit margin of different companies and their operating segments can be difficult where expenses are presented in the income statement according to their nature as opposed to their function.