Gross profit is one of the most important measures of profitability in corporate finance. Gross profit is total revenue minus the cost of goods sold (COGS). Because this metric only takes into account those expenses directly attributed to the production of items for sale, gross profit is used as a measure of a company's ability to turn revenue into profit at the most basic level. A weak gross profit often begets weak net profit. The goal of every business is to increase its profit, and they usually have a multitude of tools to be able to do so.
The cost of a product or service, as well as the price that is charged for that product or service, determines what the gross profit will be. Businesses can improve their gross profit by making changes in the cost of goods sold or the price of the product or service.
The gross profit margin is a more refined metric that compares a company's gross profit to its revenue, resulting in a percentage that reflects the portion of each dollar that remains as profit after accounting for production costs. The gross profit margin, also called the gross margin, is calculated by dividing gross profit by total revenue. For example, a company with revenue totaling $100,000 and costs of goods sold totaling $35,000, would have a gross profit of $65,000 and a gross profit margin of 65%.
The two key features of both of these calculations, revenue and the costs of goods sold, vary based on the number of products sold, the price per item, and the costs associated with production. Both fixed costs and variable costs are included in cost of goods sold, so companies look to reduce both types of expenses wherever possible, which would increase the gross profit margin.
Another way to increase the gross profit margin is by increasing price, thereby increasing revenue, assuming production and sales levels remain constant. A company would have to ensure that the increase in price is commensurate to the supply and demand of the product, otherwise, they risk losing market share to competitors who are selling a similar product for less.
To determine the variance in gross profit margin that these two types of adjustments create, calculate the margin for each price/cost scenario, and subtract the results.
Variance in Gross Margin by Changing Price and Cost
For example, assume company ABC produces table lamps. Under the current business model, ABC produces 5,000 lamps per year at a cost of $25 per lamp. The lamps sell for $50 each. In this scenario, the total revenue for all lamps is 5,000 x $50, or $250,000. The total cost for the production of the lamps is 5,000 x $25, or $125,000. The gross profit is $250,000 - $125,000, or $125,000, meaning the gross profit margin is $125,000 ÷ $250,000, or 50%.
Company ABC is looking to increase its bottom line and determines that the simplest ways to do so are to sell more cheaply made lamps or to increase prices. Management knows the market won't support a drastically inferior product nor a wildly inflated price, so it decides to combine the two factors and sell slightly inferior lamps at a marginally higher price.
It still intends to produce 5,000 lamps, but under the new model, each lamp only costs $17 to produce and sells for $55. The total revenue is now 5,000 x $55, or $275,000, and the total cost is 5,000 x $17, or $85,000. The new model then yields a gross profit of $190,000 and a gross profit margin of 69%. This represents a 19% increase over the original gross profit margin.
The Bottom Line
Companies use comparative analysis like the example above to determine what levels of production, cost, and price yield the greatest profit margin. This type of analysis can also be used retrospectively to determine the cause of declining profits due to sales volume, pricing, or production costs. By making small adjustments to one or all of these contributing factors, companies can increase profits at the most basic level, paving the way for a healthier bottom line.