The gross profit rate, more commonly referred to as gross profit margin or gross margin, measures how efficiently a company that produces goods or services operates. It's calculated by dividing the company's gross profit by net sales, and multiplying the result by 100 to determine the rate or percentage. In general, higher margins are better, because this means that the company spends less on overhead costs such as administration. You can determine whether or not a company is growing by analyzing several consecutive years of gross margin results.
What Gross Profit Includes
Understanding what income statement components are used to calculate the gross profit rate is essential to understanding why it's important. Income statements, also called profit and loss statements, report a company's earnings and expenses over a set period of time, usually a month, quarter or year. Calculate gross revenue by subtracting all of the "direct" sales costs, often called the cost of goods sold, from total revenue. Direct costs don't include indirect costs -- called overhead -- such as administration, and each business uses its own definition of what is and isn't a direct cost.
Why It's Important
The gross profit rate tells the analyst how much a company must earn to cover its operating costs and turn a profit. Because a growth in sales usually corresponds with a growth in expenses, companies usually try to increase gross margin by keeping expense growth small or static while increasing revenue at the same time. Analyzing several years or reporting periods of results tells a great deal about how efficiently a company operates; generally, an efficient company should aim for increasing margins. Margins increase when sales or prices rise while expenses stay the same (or increase less quickly than revenue).
Why It Decreases
There are several reasons that a company's gross profit rate decreases. If the volume stays the same and the selling price of the good or service drops, then so will revenue; if the associated expenses stay the same, then the gross profit rate decreases. Alternatively, if the cost of the raw materials required to make the product rise and the company opts to keep its sale price the same, then the margin will decrease as well. Finally, if the company lets its overhead costs rise faster than sales increase, then the profit rate also decreases.
Companies that utilize historical gross profit rate data are better able to plan for future expenses, because the data indicates whether or not the business is operating efficiently. The data also indicates whether or not sales and expenses are growing or slowing. Management can predict how much they need to earn to cover their direct and indirect expenses, and when this data is combined with market knowledge, it's a powerful analytical tool.