Gross profit margin shows how well a company generates revenue from the direct costs like direct labor and direct materials involved in producing their products and services.
Gross profit margins turn negative when the costs of production exceed total sales. This could be an indication of a firm's inability to control costs. On the other hand, negative margins could be the natural consequence of industry-wide or macroeconomic difficulties beyond the control of company's management.
What Is Gross Profit Margin?
Gross profit is the revenue earned by a company after deducting the direct costs of producing its products. For example, if it costs $8,000 to manufacture a car, and the finished product sells for $24,000, the difference of $16,000 is the gross profit.
Gross profit is calculated by subtracting the cost of goods sold from total revenue. If the resulting gross profit figure is divided by revenue, you are left with the gross profit margin. This number demonstrates what percentage of revenue eventually becomes gross profit.
Reasons for a Negative Gross Profit Margin
A negative gross profit margin can occur when the costs exceed the revenue generated from the sale of the product. There are several reasons why a company might experience a negative gross profit margin, and some of them are outlined below.
Declining sales could lead to revenue declines, while costs remain the same or become elevated.
Poor pricing of a product could lead to a lower-than-expected profit per item and ultimately lead to a loss.
Poor marketing for a new product launch could lead to declining revenues and a loss. For example, if a company manufactured a new product ahead of its launch, and the sales were lackluster, the company would be stuck with the inventory. The company may need to reduce the price of the product to move the excess inventory and get saddled with a loss.
Increased competition could force a company to cut its prices to maintain its customer base and market share. As a result, revenues would decline, and a loss could incur since costs would likely remain the same.
Raw material cost increases can wipe out profits and lead to a loss. For example, if a company signed a contract to deliver its product to a customer and the price of the raw materials increased, exceeding the price of the product, gross margin would be negative.
Labor cost increases can lead to a higher-than-expected cost of goods sold. For example, if a company experiences delays in getting an order out for a large customer, management might have to pay employees overtime or hire additional help to get the order filled.
A recession can reduce profits for companies as consumers reduce spending and businesses scale back operations. For example, home builders and construction companies might experience negative gross profit margins following the collapse of the housing market. The excess inventory of homes would likely be sold for a loss if the recession was severe enough, as in the case of the Great Recession.
A substantial rise in interest rates can have a negative effect on some industries. For example, if rates rise too quickly, auto manufacturers might suffer from lower sales, since many consumers finance or borrow to purchase a new car. Higher interest rates might cause consumers to be unable to afford the car payment, and the result is excess inventory for car makers, leading them to sell their cars for a loss to unload their inventory.
How to Interpret Negative Gross Profit Margin
Gross profit margin should be interpreted within the context of the industry and past company performance. Otherwise, a negative margin could mislead you into believing that management made mistakes or failed to control costs. Many well-run companies can experience a loss in the short-term, such as travel companies and airlines following 9/11. If a company's management makes adjustments, or the exogenous shock abates, profitability could return. However, if there's a pattern of losses over several quarters, it may be an indication of a more systemic long-term problem.
For more on profit margins, please read "What Is Considered a Healthy Operating Profit Margin?"