When you run a business reviewing key financial metrics is vital to monitoring your business health. Having a handle on your gross profit margin will give you a feel for how your business is performing and it is making enough profit to cover its overheads and even pay your salary.
What is Gross Profit?
Gross profit is the amount a business makes after deducting all the costs of associated with delivering a service or product sold.
Gross Profit = Turnover – Direct Costs
What is Gross Profit Margin?
Gross profit margin expresses gross profit as a percentage
Gross Profit/Turnover x 100 = Gross Profit Margin
An Example of Gross Profit and Gross Profit Margin
Here is an income statement the first three lines of which represent the calculation of gross profit.
Reading the accounts we can see the following for Example Accounts Limited:
|Gross Profit Margin||74%||84%|
Why is Gross Profit Important?
Understanding gross profit is vital for business owners because it is a measure of how much profit from selling their product/service is made to pay for overheads.
In Example Accounts Limited we can see that turnover has gone up between 2016 and 2017, as has its gross profit covering the amount they need to pay for the business overheads.
Simply speaking, Example Accounts Limited is a viable business because it makes enough money to cover its costs of being in business (things like rent and salaries) and it made more profit in 2017 than 2016, which makes sense since turnover has gone up too.
Gross Profit Margin
Looking at the results of Example Accounts Limited we can see that gross profit margin in 2016 was 84% but this reduced to 74% in 2017.
What does this mean?
Even though Example Accounts sold more in 2017, the margin was lower and is worth investigation because it shows that the business delivered its product less efficiently. Although it made a profit, the cost of delivering its product have gone up compared to 2016.
Here are a few things the owners of Example Accounts Limited could do:
- Investigate what costs have increased by making a detailed review of its cost base;
- Review the products sold to understand whether the was a boost in sales for a product with a lower margin or sold at a lower cost than 2016 (perhaps a discount was offered or the market has become competitive);
- Check with their accountant that costs have been recorded correctly in their books and there are no prepayments, for example or stock is counted correctly;
- Go back through supplier invoices to check they have charged correctly;
- Conduct a review of the delivery process to see whether costs have gone up and why.
Gross profit margin is a fairly simple calculation but it is a worthwhile metric to run on a monthly basis to understand how your business is performing.