Gross profit ratio is an important indicator used to evaluate the profitability of an enterprise’s production and business activities. make the right investment decisions. So gross profit margin what? Calculate how?
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What is Gross Profit Margin?
Gross profit margin (also known as Gross Profit Margin) is an indicator used to express the ratio of gross profit on revenue of the main production and business activities of an enterprise.
This is considered an important indicator when assessing the profitability of a business. Through the gross profit ratio to know the amount of profit the business has earned in a certain period of time.
Gross profit margin is expressed as a percentage (%). It represents profitability, the competition between businesses. This is an index that represents the difference between the selling price and the cost price of an item (cost includes manufacturing or acquisition costs, excluding indirect fixed costs such as office costs, rent, etc.) or administrative costs).
Gross profit margin is the basis for calculating the gross profit margin ratio, used to track the profit growth of the business and use this metric to compare with competitors in the market.
Formula to calculate Gross Profit Margin
Gross Profit Margin is determined by the formula:
Gross profit margin (%) = Gross profit / Sales
Gross Profit = Sales – Cost of Goods Sold (COGS)
Revenue is the total amount of money that an enterprise earns from production and business activities in the process of buying, selling and exchanging goods.
Cost of goods sold is all the costs that need to be used before the product reaches the consumer. The lower the cost, the cheaper the product reaches the consumer.
These costs are calculated on each product and paid by the consumer, including costs involved in production activities, costs incurred during storage, transportation, storage, communication support, etc. Based on the cost of goods sold, the business calculates the profit earned on each product.
In case sales are replaced by net sales, the gross profit margin is calculated by the formula:
Gross profit margin (%) = Gross profit / Net sales
Sometimes gross profit ratio is substituted for gross profit to assess the financial situation, efficiency in consumption and sales of the business. It reflects on gross profit, how much percentage of the enterprise’s revenue in production and business activities is this profit.
The higher the ratio, the more gross profit, showing that the financial situation is secure and the business is operating efficiently.
Meaning of Gross Profit Margin
There are multiple classes of profits that help analysts evaluate a business’s performance, including gross profit, operating profit, and net income. Each level provides information about the profitability of the business.
Gross profit helps analysts see how effectively a company makes products relative to its industry competitors. When calculating according to gross profit, it is possible to control the profitability ratio, orient for further development, and allocate capital appropriately to achieve the highest efficiency.
Gross profit margin helps analysts to model production and business activities with quantitative data. This index measures how much revenue each dollar of revenue earns, often used to compare with businesses in the same industry.
Gross profit ratio is used to assess whether an enterprise’s production and business activities are effective or not, and whether the business has potential for development. If the ratio is higher, the business will earn higher profits, the business is operating effectively, the products are sold well, the costs are well controlled and will be more optimized.
Based on the gross profit ratio to compare the business with the competitors in the same industry in the market, determine the position and position of the business, the operation process in the market is good or not.
If the calculated ratio is lower than expected, businesses can rely on it to adjust costs reasonably, come up with a reasonable plan to develop efficient production and profit processes.
When comparing enterprises in the same industry, it is common to compare businesses with higher gross profit that will do better in business and sales. This is an inaccurate comparison because gross profit does not accurately reflect the performance of the business, but there are many factors affecting this index such as business sector and scale of operation. Therefore, it is necessary to find out clearly before placing the two businesses on the comparison table.
Example of Gross Profit Margin
To better understand what gross profit margin is, let’s analyze some specific examples:
During February 2022, company XYZ produces furniture with a turnover of 30 million USD, calculated on the value obtained through specific orders. In which, the cost of goods sold (the cost of participating in the production of products is determined based on a part of the product value) is worth 15 million USD.
Based on the calculation formula, we have:
Gross profit = Sales – Cost of goods sold = $30 million – $15 million = $15 million
Company XYZ Gross Profit Margin = Gross Profit / Sales = $15 million / $30 million = 0.5 = 50%
Thus, the gross profit margin of company XYZ is 50%, the profit is half of the sales. This means, for $1 of revenue of company XYZ, there is $0.50 in gross profit.
A business has gross profit of $20 million, revenue of $200 million.
So gross margin = ($20 million) / ($200 million) = 0.1 = 10%
If in the following year the company’s gross profit increases to $30 million, sales increase to $400 million.
Gross margin = ($30 million) / ($400 million) = 0.075 = 7.5%
Based on the example that can be seen, when trying to increase gross profit, it is also necessary to find a way to increase the gross profit ratio by the same proportion.
How much Gross Profit Margin is good?
The higher the gross profit ratio, the higher the profit earned by the enterprise, proving that effective business activities help maintain and develop the business in a positive direction.
However, this does not mean that a low gross profit margin means that the business is not operating efficiently. Therefore, based on the individual context of each business and each industry to evaluate this indicator.
In fact, there is no exact answer about how much gross profit margin is good because each business field, each industry and production scale will have different ratios.
When applying the gross profit ratio, it is in the comparison between competitors in the same industry in the market and comparing the profit rate of the same enterprise over the years to analyze the profit trend.
Gross Profit Margin is considered good when.
Gross Margin is stable over time
Enterprises always want to maintain the Gross Margin index at a stable level, except in cases where there is a change in the scale of production and business or there is competition with enterprises in the same industry that causes this index to fluctuate.
If the gross profit margin of a business at 30 – 50% suddenly drops to ½, the reason should be considered. The significant fluctuations without arising may be due to factors such as increased raw material costs or production line problems, etc.
If the gross profit margin increases suddenly, it is possible that the business is recovering from the crisis period or has overcome problems such as production lines, production methods, etc.
Gross profit margin increased over time
The increase in the rate is a positive sign, showing that the business is doing well and the production process is improved, the quality of products is good, bringing efficiency in the business process.
This proves that the business is developing and has a high competitive advantage and has a strong foothold in the market.
A business grows as revenue grows and gross profit margin increases over time. There are 3 ways to improve this ratio:
- Increase the selling price of products, keeping the original cost of goods sold
- Increase product selling price, decrease cost of goods sold
- Between the original selling price of the product, the reduction in the cost of goods sold
Gross profit margin higher than industry average
Just because a business has a low profit margin doesn’t mean it’s inefficient. Because the comparison of an efficient business enterprise is not based on the ratio of that business to the average index of the same industry of that business.
Example for you to easily visualize in this case:
Suppose in 2020, the Gross Margin index of Vinamilk is 47.9%, Hoa Phat Group is 22.7%. In the market, if Vinamilk is the leading enterprise in the dairy industry, Hoa Phat is the number 1 corporation in the steel production industry.
When comparing the Gross Margin index of these two groups, it is impossible to show which company is better because the two enterprises are not in the same industry and the production costs are also different. Therefore, in order to evaluate which businesses operate effectively, it is necessary to rely on the average gross profit rate of the same industry of the enterprise.
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