Talking Cents

Gross Profit measurement and why you need to know what it is

Continuing our series of blogs on breaking down financial reports, using simple easy to measure ratios, let’s take a look at gross profit margin.

Gross profit margin ratio really only applies to businesses that sell goods by creating a product such as restaurants creating meals or builders constructing property and so on.

The gross profit is worked out by first getting your total sales figures for the period you want to look at. Next, you need to determine your total direct costs for those products you’ve sold. These are the direct materials used in creating your final product only. (Do not include general business expenses such as rent or telephones as these are administrative expenses.)

As an example, if a Subway franchise spends $18,000.00 on food materials and has sales of $55,000.00 for the month then you would work out the gross margin as follows:-

Gross Profit = $55,000.00 - $18,000.00 = $37,000.00

($37,000.00/$55,000.00) = 67.27%

In this case the gross profit margin for the month is 67.27%.

What does all this mean and why is gross profit margin important to my business, I hear you ask?

• Gross profit margins that are falling can indicate margin erosion due to rising supplier prices. Solution here is to either carefully consider raising prices or finding less expenses suppliers.
• Check your levels of wastage to make sure you aren’t stocking up too much on raw materials.
• For budgeting, all other costs can be determined quite accurately. Based on your fixed costs, you can work backwards to know what gross margin you need to make to cover your fixed expenses with a net profit margin built in to the numbers.
• The ATO now uses average percentages across industries to target businesses as potential audit clients of their margins fall outside your industry averages.
• Rising or steady gross profit margins are signs of a healthy business. If you can grow your sales and keep the GP margin consistent then you know you will be clearing a higher net profit from those extra sales.
• Using the ATO benchmark percentages is also a great way of comparing your small business to the rest of your industry, to know if you are on track with your business or falling behind your competitors. 

For more insights into your small business reports contact mas accountants, the original accountants for small business in Sydney and Melbourne.