The gross profit is shown in your financial statements on the profit and loss account, after sales and cost of sales (also known as direct costs). It tells you what the business made after paying for the direct costs relating to the sales.
It may look something like this
Total cost of sales/direct costs £(75,000)
Gross profit £25,000
Gross profit margin % 25%
Depending on the industry you are in will depend on what costs are included in the cost of sales/direct costs.
A business in the construction industry may have labour and material as cost of sales, whereas a business in the transportation industry may have labour (drivers) and fuel as a cost of sale.
In the construction business the sale will likely be a markup on materials and labour costs, therefore the amount of materials and labour required for a project will be a direct cost. Whereas fuel spent in the business will be an overhead, not a direct cost, as it is unlikely any sales will be generated due to distance travelled and fuel consumption, it is just a cost most businesses incur, such as telephone, computer and rent.
In the transport business the spending on fuel will be directly related to sales, as the sale may be related to distance travelled using more fuel, and these are related. Whereas the cost of renting an office to direct the transport doesn’t change with sales, as the cost will be fixed whether two journeys are made that day or twenty journeys, the fuel cost will change depending on the number of journeys so it is a direct cost.
Gross Profit Margin (%)
Gross profit margin is usually expressed as a percentage. It is the percentage of gross profit compared to the sales, the formula being gross profit/sales x 100 = Gross Profit Margin % (GPM).
It is an important indicator for your business, and can tell you a lot about how the business is performing and how strategies adopted in the business and external factors have influenced the business.
All being equal, the gross profit margin should stay consistent. In the example above, if the sales were doubled to £200,000, we could expect the direct costs to double to £150,000, and the gross profit to double to £50,000. However the gross profit margin will be static at 25% (50,000 / 200,000 x 100).
If the gross profit margin had dropped to 20%, then it could indicate a number of things such as:
Sales prices were lowered to attract more customers, increasing sales by increasing the volume of sales, but decreasing profits.
Costs of materials from suppliers went up, but contracts with customers were at a fixed price so the increase could not be passed on and profits decreased.
Labour in the market is scarce, so as sales increased you had to pay new workers more to attract them.
The list could go on forever. By reviewing the Gross Profit Margin regularly you can see how decisions you are making and external factors are affecting the business. If a downtrend continued and you didn’t spot it, then you may struggle to pay overheads, debt payments or make a net profit.
Similarly if the gross profit margin had increased to 30%, then it could indicate that there was an abundance of labour available so prices were lower, or that you had negotiated a bulk discount with a materials supplier so you made a higher margin.
Overheads tend to be more static, if sales double it doesn’t mean telephone costs or rent would double, but direct costs most likely will. Overheads are linked to net profit and net profit margin, which we will cover in another post.
If you would like to find out more about how we can help you track the key performance indicators and metrics in your business please contact us here or find out about our virtual finance director service here.