Chapter 7
Inventory: Merchandising Transactions
184
Gross Profit Margin: A Profitability Ratio
If Company A has sales revenue of $100,000, and its COGS is $60,000, the gross profit is $40,000.
When gross profit is expressed as a percentage, it is calculated as shown below.
Gross Profit Margin = Gross Profit ÷ Net Sales x 100%
Net sales is equal to the difference between sales revenue and any sales returns, allowances, and
discounts. In this example, Company A does not have any sales returns, allowances, or discounts
so its sales revenue is equal to its net sales. Gross profit expressed as a percentage of sales is called
gross profit margin. The gross profit margin represents the percentage of sales left over to pay for
all the operating expenses.
Gross profit margin is more meaningful when comparing the results from one period to another or
among different companies. If Company B has sales of $500,000, with a gross profit of $175,000,
which of the two companies is performing better? You may think that Company B is performing
better because a gross profit of $175,000 is greater than a gross profit of $40,000. However, to
assess the results properly, it is important to compare the two percentages
Company A
: $40,000 Gross Profit ÷ $100,000 Sales × 100 = 40%
Company B
: $175,000 Gross Profit ÷ $500,000 Sales × 100 = 35%
The results show that Company A is more efficient because it used only 60% of revenue to cover
the cost of the product, leaving 40% of every dollar to contribute toward its operating expenses.
Company B, on the other hand, used 65% of its revenue to cover the cost of goods sold, leaving only
35% of each dollar to contribute toward its operating expenses.
Keep in mind that ratios should be compared within industry groups, taking industry norms into
account. Suppose Company A and Company B are both hardware stores and other hardware stores
have a gross profit margin of 38%. In this situation, Company A is doing better than the industry
average and Company B is doing worse than the industry average.
