GROSS PROFIT MARGIN: A Simple Explanation - YouTube

Hey there welcome back to Accounting Stuff  I'm James and today we're kicking off a new  

series covering financial ratios these are the tools that help us analyze

financial statements first up Gross Profit Margin

What is Gross Profit Margin? Gross Profit Margin is Gross Profit

divided by Revenue it's a profitability ratio that measures a business's ability

to generate Gross Profit from each unit of Revenue earned

we often show it as a percentage so if that's the case then remember

to multiply by 100 Gross Profit is a business's Revenue

minus its direct Cost of Sales so here's another way to write the same equation

and keep in mind that Cost of Sales goes by a few different names

Cost of Services if a business sells services  and Cost of Goods Sold if it sells products

anyway let's break this down so we can get a full understanding of how Gross Profit Margin works

we'll start with Profit you can find businesses Profit on its income statement

an Income Statement is a financial report that summarizes Revenue earned

and Expenses incurred over a period of time

Profit is the difference it's the financial gain generated

when Revenues are bigger than Expenses

alright so what about Profit Margin? Profit Margin is the ratio between Profit and Revenue  

it shows us how much Profit a business generates  for each dollar of Revenue earned

or when we times it by 100 what percentage of Revenue

it's able to convert into Profit for example here's the Income Statement

for a business called MAD they're a tech company that makes processors

and graphics cards out of California last year MAD earned one billion dollars in revenue

and they incurred 880 million dollars in Expenses the difference of 120 million dollars is their Profit

which is the financial gain to their business MAD's Profit Margin is 120 million dollars

divided by 1 billion dollars that's 12 cents of Profit generated on every dollar earned

a 12% Profit Margin if we multiply by a hundred now how does Gross Profit fit into all of this?

let's jump back to the Income Statement

this one's very compressed in reality businesses split out their Expenses

into a few different buckets first we take away the direct Cost of Sales

then all the indirect Operating Costs like research and development,

selling, general and administrative expenses, depreciation and amortization

and finally we subtract interest and tax expenses as you can see the Income Statement

shows three different types of Profit the big one at the top is called Gross Profit

the middle one is Operating Profit and the smallest one at the bottom is Net Profit

the bottom line so what is Gross Profit Margin?

at the start we said the Gross Profit Margin is a business's Gross Profit divided by its Revenue

it measures how much 'Big Profit' they're able to generate from each dollar of Revenue they earn

Gross Profit Margin only factors in a business's direct Cost of Sales

it totally ignores all of the indirect operating expenses, interest and tax

that we can see further down the Income Statement we use different ratios to measure those

which i'll explain in my next videos so remember to click subscribe if you'd like to see them

I've also put together a new cheat sheet which shows all the different profitability ratios

if you'd like to support this channel then you can  buy it on my website the link's in the description

example time what was MAD's Gross Profit Margin last year?

if we expand out their Income Statement we can see that they earned Revenue

of 1 billion dollars and they incurred 500 million dollars in Cost of Goods Sold

that left them with a gain in Gross Profit of  500 million dollars so their Gross Profit Margin is

500 million dollars in Gross Profit divided by  one billion dollars in Revenue

that's 50 cents of Gross Profit generated on each dollar earned or 50% if we multiply by 100

but how should we interpret this? is 50% good or bad?

it's hard to say so let's make some comparisons first what was the year on year movement

in Gross Profit Margin?  let's compare MAD's current and prior year Income Statements

we can see that they had a Gross Profit of 315 million dollars in the previous year

when we divide that by their Revenue of 700 million dollars that's a Gross Profit Margin

of 45% so MAD managed to raise their Gross Profit Margin by 5% year on year

that's good news because bigger is better they managed to generate five extra cents

of Gross Profit on each dollar they earned they also managed to increase their Revenue

from 700 million dollars to 1 billion dollars

things are looking promising but how does their Gross Profit Margin

compare against their competitors? here are the current year Income Statements

for MAD and INLET both of these businesses are in the same industry so it's  fair

for us to compare their financial ratios INLET earned 7.8 billion dollars in Revenue

which is a lot more than MAD managed over the same period they incurred 2.34 billion dollars in Cost of Goods Sold

leaving them with a Gross Profit of 5.46 billion dollars that's a Gross Profit Margin of 70%

which is a lot higher than MAD's it seems like INLET is outperforming them

but let's make sure by checking out INLET's year on year Income Statement

we can see that their Gross Profit Margin actually decreased from 75% to 70%

hmm.. maybe things aren't as clear as they seemed  what could cause a decrease in Gross Profit Margin?

Gross Profit Margin is Gross Profit divided by Revenue and we know that

Gross Profit is Revenue minus Cost of Sales so there are really only two ways that

Gross Profit Margin can go down either the sales prices are dropping

which could be down to discounting or a change in sales mix to lower margin products

or the Cost of Goods Sold are going up maybe there's been some supply issues with materials

or an unfavorable FX rate on foreign purchases perhaps direct labor costs have gone up

who knows! on the flip side an increase in Gross Profit Margin

could be caused by higher sales prices there could be a larger demand for the products or services

or a change in the sales mix to higher margin products  alternatively Cost of Sales might have gone down

the business could have negotiated a discount with a supplier or switched to a cheaper one

they could have automated part of their production process or maybe they're experiencing some economies of scale

with financial ratios there's plenty to think about context is key

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if you'd like to see any other financial ratios have a good one!