What is Gross profit margin ratio ?
The Gross profit margin ratio or simply GP margin is a profitability ratio that helps in understanding the performance of the company.
It shows how much profit is the company making from its core business operations.
Gross profit margin meaning
Gross profit margin basically means how much profit is the company making on each dollar of sales.
Here gross profit refers to the profit earned by the company after reducing only direct cost of production. Other types of indirect expenses are not reduced.
This profitability margin is the most important performance metric that every investor or lenders track since it indicates the core performance of the company in its business.
Gross profit margin formula
The formula for the Gross profit margin is quite simple.
We take Gross profit in the numerator and Sales in the denominator.
Below aspects has to be kept in mind while calculating the numerator and denominator.
- It refers to profit earned from sales after reducing direct cost of sales.
- The direct cost of sales are the expenses that are directly attributable to the production of goods or rendering of services.
- Other expenses like administrative expenses, general expenses, interest cost or even taxes are not direct cost of sales.
- Hence these are not reduced from sales to arrive at gross profit.
- Sales refer to normal revenue the company generates from its core operations.
- Both, cash sales and credit sales should be considered while calculating Sales.
- Any goods returned from the customer have to be reduced. Hence, Net sales has to be considered.
- Sales value should not include any tax amount collected from customers. Hence, sales value should be net of any taxes
Let us understand Gross Profit with a hypothetical example.
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Gross profit margin example
Let us look at our 1st example.
We take Company A and Company B for calculating GP margin
Values given in the examples below are in $ millions.
Consider the below-given income statement for both the companies.
To calculate Gross profit margin, we need
- Gross Profit
Let us calculate gross profit for both the companies
- Revenue = $2,000
- Cost of sales =$500
- Gross Profit= (Revenue – cost of sales ) = ($2,000 -$500) = $1,500
- Revenue = $3,000
- Cost of sales =$1,500
- Gross Profit= (Revenue – cost of sales ) = ($3,000 -$1,500) = $1,500
Let us calculate Sales value for both the companies.
- Revenue = $2,000
- Revenue = $3,000
Now that we know all the values, let us calculate profit margin for both the companies.
Gross profit margin= Gross Profit/ Sales
- Company A = $1,500/ $2,000 = 75%
- Company B = $1,500/ $3,000 = 50%
What this means is that Company A makes 75% gross profit on each dollar of sales.
But, Company B makes only 50% gross profit on each dollar of sales.
It is interesting to note that although both the companies have the same gross profit, their gross profit margins are different.
GP margin for Company B is lower than that of Company A.
This is because Company B is not able to manage its cost of sales optimally.
Raw materials cost and even salary cost is high in the case of Company B
Nonetheless, companies in our example are making a high double-digit gross margin. This is not always the case with public companies in a very competitive environment.
Gross profit margin for Walmart
In our next example, let us calculate the GP margin using excel
You can download the Gross profit margin template for Walmart using the below option.
Below shown is the Consolidated Income Statement of Walmart Inc.
In the case of Walmart, gross profit can be easily calculated from Income Statement.
To arrive at the Gross profit, the Cost of sales has to be reduced from revenue.
Gross profit =Revenue – Cost of Sales = $514,405 – $385,301 = $129,104
Revenue = $514,405
Now that we know all the values, let us calculate the gross profit margin ratio for Walmart
Gross Profit margin = Gross Profit/ Revenue = ($129,104 / $514,405 ) * 100 = 25%
As evident, Walmart has a moderate gross profit margin of only 25%
What this means is that Walmart generates 25% of gross profit on each dollar of sales it makes.
Gross profit margin interpretation
- As we have already understood, the GP margin indicates how much gross profit does the company makes from each dollar of sales.
- Generally high gross profit margin indicates that either the company is selling the goods or services at a very high price or the company is controlling its direct cost of sales more efficiently.
- A low gross profit margin is often a result of the high direct cost of sales.
- Companies with limited pricing power and operating in a highly competitive environment suffer lower gross profits. Hence, the lower gross profit margin
Any financial ratios will not give a clear picture when analyzed on a standalone basis.
Hence trend analysis has to be performed for a particular ratio.
This helps in understanding about the sustainability of the performance in the future.
As evident, GP margin in case of Amazon has increased significantly from 30% to almost 40%
Such an increase in gross profit margin is generally not seen in any listed public companies.
Amazon was able to increase its gross profits because of the gradual change in the product mix.
Also, since the company enjoys pricing power, it was able to sell goods/services at a higher price while keeping its cost of sales steady.
All these aspects helped Amazon to increase its gross profit margin.
Comparison with similar companies
It is also important to track GP margin of various companies in different sectors.
This helps in understanding the dynamics of a particular industry.
Walmart vs Home Depot
GP margin for companies in the retail sector varies with companies in sectors like e-commerce or oil and gas.
In the case of Home Depot – a home improvement retailer ( supplies tools, construction products, and various similar services), you can observe that the GP margin is almost stagnant at around 34% for the past 5 years.
The company is not able to increase it’s GP margin because it is operating in a very high-cost environment.
But, when you look at Walmart, the GP margin is even lower than that of Home Depot.
GP margin for Walmart is stagnant at around 25% for the past 5 years. Even this company is not able to increase its GP Margin.
This indicates either the lack of pricing power or lack of cost control mechanism.
Nonetheless, these companies are able to at least maintain their gross margins.
We have already seen the gross profit margin profile of Amazon as part of trend analysis.
The company has turned around strategically by altering its product mix and selling high margin goods/services.
Hence, the Gross profit margin for Amazon has increased from 30% to almost 40%.
ExxonMobil is a US-based multinational oil and gas company.
Generally, oil and gas companies are into highly capital intensive business.
But, we can see that the company was able to increase its gross profit margin from 25% to 31%.
GP margin increase in such cyclical sectors has to be seen cautiously. Since the company is operating in the oil and gas sector, its Raw material costs are always exposed to global fluctuation in oil prices.
Additional analysis has to be carried out to understand the sustainability of such margins.
Facebook vs Google vs Microsoft
When you calculate the gross profit margin ratio for tech-based companies like Apple, Facebook, Google ( Alphabet) and Microsoft, you will observe that the ratios are quite interesting.
Also, one can clearly see the huge gap in GP margin between companies like Apple and Facebook.
In the case of Apple, the GP margin is stagnant at around 40%.
Undoubtedly, Apple enjoys pricing power in a few segments like premium mobiles and mobile accessories.
Yet, the company is not able to increase it’s GP margins.
This indicates that although the company’s sales are increasing, there is a simultaneous increase in cost as well. This is hindering an increase in GP margins.
For the year ending 28 September 2019, Apple’s gross profit margin is 38% which is almost the same as the previous year.
It is worthwhile to note that social media giant Facebook makes a gross profit margin of a whopping 80%.
Such a very high gross profit margins indicate absolute control on its cost or better than average pricing power.
For the year ending 31 December 2018, Facebook’s Gross profit margin is 80%.
Similar to Apple, even Microsoft company is not able to increase its gross profit margins.
GP margin for Microsoft is stagnant in the range of 65%.
Although the company’s revenues are increasing, the company is not able to optimize its product mix so as to generate higher gross profits.
In the case of Google, there is a moderate fall in the GP margin.
The company’s margin was as high as 62%. But, currently, for the year ending 31 December 2018, the margin has dipped to 56%
Below are few important aspects one must consider while analyzing any company using gross profit margin ratio
Cost of sales
- As already highlighted, only the direct cost of sales has to be considered.
- Other indirect costs like general and admin expenses, interest costs, taxes, etc should not be part of the cost of sales.
- Revenue has to be after deducting sales returns, govt taxes, etc.
- Basically, net sales have to be considered.
How to increase gross profit margin?
To increase GP margin, the company may adopt below changes
Increasing Pricing Power
Best way to earn superior profits is by increasing the selling price of goods/services. Companies can increase their selling price only when they have higher pricing power.
Better cost control on direct expenses such as Raw Material, salary expenses, etc can yield great savings. This will help in earning better gross profit and thereby increasing GP margin.
Change in Product Mix
The product mix refers to a combination of multiple goods/services. Companies that are into multiple business verticals, should try altering their product mix such that it yields higher GP margins.
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