3.5.1 - Profitability ratios and markup

Gross profit margin

Gross profit margin shows how much of each unit of revenue remains after the cost of sales has been deducted.

Revenue is income from sales, before costs are deducted. Cost of sales is the cost of the goods or services sold in that period. Gross profit has not yet paid other operating expenses, such as office rent or administration. A large gross profit in money terms may simply reflect a large business; the margin makes a relative comparison possible.

In an illustrative small bakery, annual revenue is USD 120,000 and cost of sales is USD 72,000. Gross profit is USD 48,000, so its gross profit margin is $48{,}000/120{,}000\times100=40\%$. For every USD 100 of sales, USD 40 remains to cover other expenses and contribute to later profit. This is not USD 40 of cash necessarily received immediately.

If the bakery negotiates lower ingredient costs while selling the same mix at the same prices, cost of sales falls relative to revenue and the margin rises. Increasing prices can also raise the margin, but customers may buy fewer loaves. A better margin alone therefore does not guarantee higher total profit. Compare similar products, periods and accounting treatment before attributing a change to efficiency.

Operating profit margin

Operating profit margin measures what remains from revenue after both cost of sales and other operating expenses.

The margin relates this trading profit to the revenue that generated it, after the business has covered its operating expenses.

Continue the illustrative bakery's annual figures: gross profit is USD 48,000 and other operating expenses are USD 30,000. Operating profit is USD 18,000 and the operating profit margin is $18{,}000/120{,}000\times100=15\%$. The bakery keeps USD 15 of operating profit per USD 100 of revenue. Use operating profit in this numerator; substituting USD 48,000 would calculate the gross margin instead.

Gross margin may rise while operating margin falls. For example, cheaper flour could improve the gross margin, but opening an expensive sales office could raise other operating expenses by more than the saving. Comparing both margins helps locate the change. Cutting unnecessary administration may improve operating margin; cutting essential maintenance may instead cause breakdowns, lower sales and later costs. Interpret the mechanism, not just the percentage.

Net profit margin

Net profit margin uses profit for the year after finance costs and tax, rather than operating profit.

This measure includes deductions that operating profit has not yet included, so the two margins must be kept distinct.

For the illustrative bakery, suppose annual finance costs are USD 3,000 and tax is USD 3,000, with no other adjustments. Profit for the year is USD 18,000 − USD 3,000 − USD 3,000 = USD 12,000. Net profit margin is $12{,}000/120{,}000\times100=10\%$. Its gross, operating and net margins are therefore 40%, 15% and 10%: each answers a different question about the same revenue.