Gross Profit Margin Analysis

Businesses exist to produce goods or services at a profit. A variety of financial ratios can help evaluate how well a business is performing financially. The gross profit margin is one of the most critical indicators of a company's health. Since it is a percentage, it applies equally to small businesses where the actual dollar value of gross profit may be small. Because it indicates how much money is available for expansion and increasing sales, it is vital that small businesses intending to grow show a high gross profit margin.

Gross Profit Margin Analysis

The gross profit is the amount that is left after you subtract the cost of producing what you are selling from the total sales figure. The gross profit margin is the gross profit expressed as a percent of total sales. To calculate it, you add the total sales for a year and subtract the labor, materials and production overhead it took to produce those sales. You divide the result by the total sales figure and multiply by 100 to get the percent gross profit margin.

For example, if you had $100,000 in gross sales and $90,000 in overall costs, your gross profit margin would be 10%.

Efficient management, low production costs and higher sales prices all contribute to higher profit margins.

Cost of Production

An analysis of the gross profit margin starts with the costs of production. A large part of the cost of a typical product is the material that goes into making it. If you can reduce this cost, your costs of production go down, and your gross profit margin goes up.

Companies can reduce the costs of material by getting better pricing from their suppliers, by changing suppliers or by changing the materials they use.

A second major part of the cost of production is the cost of labor. Companies reduce the cost of labor per unit of a product by making their production more efficient.

They can invest in better equipment or train their workers to work more efficiently. If the cost of labor goes down, the gross profit margin goes up.

Calculating Your Pricing

The other way an analysis of the gross profit margin can lead to an increase in profitability is to look at pricing. If the company can increase prices while maintaining sales, the total sales figure increases, the costs stay the same, and the gross profit margin goes up. If the company can increase sales and keep the pricing at the same level, there may be savings in the costs due to higher volume. Generally, production overhead does not increase as quickly as an increase in production volume. The costs per unit of production go down, and the gross profit margin goes up.

The Benefits of Higher Margins

An increase in gross margin is important for a business because companies can use the money from the gross profit to increase cash flow, to work on other projects or to expand. They can spend additional amounts on marketing to increase sales. They can build new production facilities or invest in equipment to help increase production.

A small gross profit margin means a company has very little money to do anything except keep making its products at the same level.

A high gross profit margin gives a company the liquidity and flexibility to innovate, enter new markets and grow aggressively.