Probably the most revealing measure of a business’ profitability is the gross profit margin. If a business doesn’t perform well at that level of its income statement, it has little chance of delivering bottom-line profit; so a good gross profit margin is key.
On an income statement, gross profit is the first profit figure that we come across. So what does it tell us?
If you look at an income statement, you’ll see that gross profit is the profit made from revenue after deducting the direct expense incurred in making those sales. But, what are direct expenses?
Direct expenses are those that have to be incurred in order to make the sale. The most common direct expense is the cost of the inventory that was purchased and then sold.
Let’s look at an example;
Let’s assume that we’re in business as retailers of chairs and we buy them from a manufacturer. We buy them for 200 and we sell them for 500.
If we sell one chair, our income statement will look like this; Revenue 500 Cost of Sales 200 Gross Profit 300.
If we sell five chairs, our income statement will look like this; Revenue 2,500 Cost of Sales 1,000 Gross Profit 1,500.
So, in selling 5 times the number of chairs our revenue multiplied by 5 but so did our cost of sales figure because we had to buy 5 chairs from our supplier in order to sell them to our customers.
In this simple example, our direct expense is the cost of the chairs that we sold. Notice the direct correlation between the revenue and the cost of sales figure – that gives us another name for these expenses which is; variable expenses
We call them “variable” because as the level of revenue changes, so does the level of the cost of sales figure in the same proportion.
For some businesses, though, the direct expenses can also include other expenses. For example, if we had covered our chairs in paper or cardboard to protect them in transit to our customers, that would be a direct expense because the more chairs we sold, the more paper or cardboard we would have to use.
In the same way, if we paid for the transportation of the chairs to our customers, that would also be a direct expense.
An understanding of what constitutes the direct, or variable, expenses for a business is central to being able to properly analyse the gross profit margin. Let’s see why that is……
When we want to analyse the gross profit margin we convert the gross profit figure to a percentage of revenue because it’s more meaningful to us that way.
For example, in our chair sales business when we sold 5 chairs our revenue was 2,500 and our resulting gross profit was 1,500. If we convert that gross profit to a percentage of revenue we have a figure of 60%.
That indicates then that 60% of our selling price is profit. That 60% is known as the gross profit margin.
But how should we respond if that gross profit margin should reduce to, say, 50%. That’s wouldn’t be a good sign but what must have happened?
In fact, there are only two things that could have happened to reduce the gross profit margin;
One possibility is that the cost of sales figure could have increased without a corresponding increase in revenue. Alternatively, revenue could have reduced without a corresponding reduction in the cost of sales figure.
In either event, the problem is that the cost of sales (the basic input costs into the business) are no longer in the same proportion to the revenue figure. That probably implies an increase in the costs that could not be passed on to the customer, possibly because of competition in the market, the existence of substitute products that customers might buy in preference or simply that customers wouldn’t perceive value in the product at the higher price and so wouldn’t buy it.
The problem for the business is that it still has to meet its operating expenses from its gross profit so, if gross profit falls because of a reducing gross profit margin, it can have a very negative effect on the business’ ability to make that bottom-line profit.
From an analyst’s perspective, there are two issues when analysing a gross profit margin
One: Is the gross profit sufficient to cover all the remaining expenses of the business to leave a reasonable return for shareholders? The margin differs between industries so a comparison with other businesses in the same industry can be a useful guide.
Two: If the gross profit margin is falling, what caused it to fall and can the situation be rectified to get it back to where it was? If not, the business may be in long-term trouble.