Gross profit margin shows how well a company generates revenue from its costs that are directly tied to production. Gross profit margin is used as a metric to assess a company's financial health. Gross margin can also provide insight as to whether their business strategy is achieving its production, sales, and profitability goals.
Gross profit margin can turn negative when the costs of production exceed total sales. A negative margin can be an indication of a company'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 a 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. Before we can analyze gross profit margin, we need to review the components of gross profit and what costs are not included.
Revenue is the income that a company generates for a particular period, such as one quarter or one year. Revenue is also referred to as net sales since companies can have merchandise returns by customers, which is deducted from revenue.
Cost of goods sold for a company represents the direct costs and direct labor costs that are incurred in the production of goods. In other words, cost of goods sold are the costs that are directly tied to production, which can include the following:
- Direct materials such as raw materials and inventory
- Direct labor or wages for production workers
- Costs for equipment and machinery used in production
- Utilities such as heat and electricity for the production factory
- Shipping costs for the products
However, non-production costs are not included in cost of goods sold such as sales, general, and administrative costs (SG&A), which are commonly referred to as overhead costs. A company's corporate office would be considered overhead and would not be included in costs of goods sold nor the calculation of 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. The resulting number demonstrates the percentage of revenue generated from those direct costs.
- Gross profit margin shows how well a company generates revenue from its costs that are directly tied to production.
- A company's gross profit is its revenue minus its cost of goods sold, which include the costs of direct labor and direct materials.
- Gross profit margin is calculated by dividing gross profit by a company's revenue.
- If a company experiences a sudden decline in revenue or an increase in costs of goods sold, a negative gross profit margin can result.
Reasons for a Negative Gross Profit Margin
A negative gross profit margin can be reported by a company for several reasons. Below are some examples of the factors that can impact both revenue and costs leading to a negative gross profit margin.
Declining sales could lead to revenue declines, while costs remain the same or become elevated. The 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, which occurred from 2007 to 2009.
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 car payments. The result would be excess inventory for carmakers, leading them to sell their cars for a loss to reduce their stock.
Example of Negative Gross Profit Margin
For example, let's say an automobile manufacturer has direct costs or cost of goods sold of $8 million while the revenue generated from selling the cars was $12 million.
- The gross profit for the company would be $4 million or ($12 million - $8 million).
- The gross profit margin would be .33 or 33% ($4 million in gross profit / $12 million in revenue).
Let's say that the cost of steel and aluminum rose significantly, resulting in the cost of goods sold soaring to $16 million. The company responded by raising prices helping to boost revenue to $14 million. However, the company's management couldn't pass all of the cost increases onto its customers.
- The gross profit for the company would be -$2 million or ($14 million in revenue - $16 million in cost of goods sold).
- The gross profit margin would be -0.14 or -14% (-$2 million in gross profit / $14 million in revenue).
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.