Profitability Analysis
In this lesson, we will learn how to calculate and interpret the gross profit margin, mark-up on cost and profit margin. We will also learn how to compare these profitability ratios performance across different years of the business, and with other businesses.
Related Lessons:
Purpose of Profitability Analysis
Profitability refers to the ability of a business to generate enough income to pay for business expenses.
By analysing various profitability ratios, it can help business owners to:
- Identify areas to improve revenue
- Identify areas to improve operating efficiency
- Determine the return on their investments and that of the investors
Calculating Gross Profit Margin, Mark-up on Cost & Profit Margin
A) Gross Profit Margin
To calculate, we take Gross Profit divided by Net Sales Revenue and multiply the answer by 100%. This gives us the percentage of gross profit earned per $1 of net sales revenue.
(Gross Profit / Net Sales Revenue) x 100% = x%
B) Mark-up on Cost
To calculate, we take Gross Profit divided by Cost of Sales and multiply the answer by 100%. This gives us the percentage of gross profit earned per $1 of cost of sales.
(Gross Profit / Cost of Sales) x 100% = x%
C) Profit Margin
To calculate, we take Profit for the Year divided by Net Sales Revenue and multiply the answer by 100%. This gives us the percentage of profit earned per $1 of net sales revenue.
(Profit for the Year / Net Sales Revenue) x 100% = x%
Interpreting Gross Profit Margin, Mark-up on Cost & Profit Margin
Gross profit margin measures the amount of gross profit earned for every $1 of net sales made.
Assuming a gross profit margin of 30%. This means that for every $1 of net sales revenue made, the business earns $0.30 of gross profit.
Mark-up on cost measures the amount of gross profit earned for every $1 of cost of sales incurred.
Assuming a mark-up on cost of 20%. This means that for every $1 of cost of sales, the business earns $0.20 gross profit.
Mark-up on cost is also used to calculate the unit selling price of goods by adding mark-up on cost to cost of goods.
Assuming mark-up on cost is 20% and unit cost of goods is $20.
Mark-up is 20% x $20 = $4
The unit selling price of goods is $20 + $4 = $24.
Profit Margin measures the amount of profit earned for every $1 of net sales revenue made.
Assuming a profit margin of 5%. This means that for every $1 of net sales revenue made, the business earns $0.05 profit for the year.
Analysis of Profitability Ratios
Profits are influenced by both gross profit earned and expenses incurred. Gross profit, in turn, is affected by cost of goods and the mark-up, which determines the selling price of goods. The selling price then influences the quantity of goods sold.
Therefore, gross profit margin, mark-up on cost, and profit margin are analysed together to help businesses identify strengths and weaknesses in managing their trading activities.
Mark-up on cost > affects selling price > affects quantity sold
Selling price, quantity sold & cost > affects Gross profit margin
Gross profit margin & expenses > affects Profit margin
An increase in mark-up on cost suggest that the business increased its selling price. This may lead to an increase in gross profit margin if quantity sold remain constant or have increased.
If the increase in mark-up on cost resulted in a decrease in the quantity sold, gross profit margin may remain constant if the decrease is compensated by the increase in price.
However, if the quantity sold is significantly reduced and outweigh the increased in price, gross profit margin declines.
Besides mark-up on cost, gross profit margin is also affected by cost of goods sold. A decrease in cost of goods leads to an increase in gross profit margin if selling price has remained the same or higher.
Finally, increase in gross profit margin can lead to a higher profit margin if operating expenses decreases or remain constant.