In a company, matters to do with finance play an integral role in determining the direction of the business. It is always prudent for the management and employees concerned to ensure that they monitor various aspects of company’s finance to make it financially sound. Financial ratios are one aspect that needs to be understood and given great importance and attention.
Gross profit refers to a financial measure that informs you about the overall financial health and profit of the organization. It reveals the percentage of money that remains for operations, debt repayment, and expansion, payment to distributors and shareholders as well as miscellaneous expenditure among others.
The Value wise formula for gross profit is Total sales value – Purchase value = Gross profit. Note that gross profit does not assume the expenses which are undertaken to make sales (salaries, advertising etc). Hence, after calculating gross profit, most companies calculate net profit which is calculated as Gross profit – Expenses = Net profit. The above two formula’s are in value and not percentage.
Significance of Gross Profit
Ordinarily, you would think that this particular financial element in an organization is merely for formality. However, it is important to understand that it plays a critical role in determining whether or not the business is and will be financially viable to cater for the costs and other related items revolving around the organization. It is one of the several profitability layers that financial experts monitor in attempts of evaluating the company’s performance.
This profit margin is also important because it helps in providing a critical measurement for profitability that the potential investors would use in establishing whether or not to invest in that particular company. It also makes it easy for financial analysts to carry out a comparison of your firm with other business in that particular industry for purposes of finding out how you are faring on in the industry.
Essentially, the metric provides useful information in understanding the financial position of an organization in regards to success and sustainability of a good or service that it offers. Primarily, it implies that the higher the rate, the more the organization retains on every sales value to cater for other financial obligations and costs that it has to meet.
What you should know about gross profit margin
Importantly, you need to know that understanding these metrics play a critical role in business. If it is inadequate, it negatively affects the operations and growth of the company in the sense that it will not be able to do a wide range of expenses revolving around operations. It also essential for this profitability layer to always be stable should the organization yearn to attain desirable returns and growth. The only exception for a stable gross profit margin is when the company is probably experiencing changes in its business model.
Several factors may lead to changes in gross profit margin. For instance, implementation of appropriate regulation may drive it to extreme ends hence having either positive or negative impact. Changes in organizational pricing strategy may also affect gross profit since it determines the buying pattern that customers will adopt, which eventually causes an effect on the profits realized within a stipulated period.
Gross profit margin can only rise, decrease or stay at the same point. These are the only three trends in this tool. However, it is also significant to factor in various aspects of the firm in efforts of estimating this margin for rational calculation such as company’s inventory level, its competitiveness in the industry and invention of new products among others.
For instance, when a company has a high level of inventory level, it simply shows that its sales profit margin will decrease. Thisis attributed to the fact that having a lot of unsold items places you in a probable position of selling them at lower prices in efforts of clearing your inventory. For the moment, variable cost remains constant given that the items were manufactured a while ago.
Gross Profit Margin calculations
Gross profit margin is an expression of gross profits in the form of apercentage. It varies among different industries and retailers depending on several factors such as products or service among others. Calculation of this percentage involves subtraction of cost of goods (COGS) from the total revenue collected and then dividing the difference by total revenue. A breakdown of these three major steps includes the following;
Here is the formula for finding this particular metric;
Gross profit margin = (Revenue – Cost of Goods) / Total Revenue
Example of Gross profit margin
Let’s say that company XYZ makes toys. If XYX reported $10 million in total revenue for a particular year, and cost of goods, which includes direct labor and cost of materials used of $ million, we can as well use this formula in finding the gross margin for XYZ.
Gross profit margin = ($10,000,000-$4,000,000) / $10,000,000
Gross profit margin = 60%
The gross profit margin percentage indicates that company XYZ is left with a total of 60% of its revenues after paying all the cost of materials and direct labor (COGS) for producing the toys. This XYZ’s gross profit, which is equivalent to $6 million in the example mentioned above, is a representation of the amount of money left over for Company XYZ to carry out its various undertakings including expansion, taxes operating expenses, taxes and payouts among much more.
This percentage, therefore, helps in providing real-time information for the company to plan for its finances accordingly given that they have the amount they are confident would assist in covering all the expenses without necessarily affecting production negatively. What it essentially means is that when a company has a higher percentage of gross margin, it shows that there is a significant amount of money available to involve in current or future business activities.
A gross profit margin is a significant tool that every organization that has a vision needs to be utilized in determining its financial aspects. Business cannot be operated blindly without making sure of what amount of money to invest and where to invest respectively.
It requires that you find out the exact sum of money that you would wish to involve in various business undertakings without affecting the stability of the operations as well as the financial capability of the organization. It is also important to note that this tool is ideal for giving your company prospective investors that would like to be associated with it.