- December 5, 2017
- Posted by: UpVue
- Category: Accounting & Finance Know-how
As we have done with the inflow and outflow of cash, let us check what is left out as balance. Or call it a better name, Gross Profit. It is accounted by deducting Cost of Goods Sold (COGS) from the Total Revenue of firm. The deducted cost includes only those associated with production and sale, not the management cost or depreciation.
Gross Profit by itself tells very little about the profitability of a firm. Rather it directs us to a larger determinant of economic health of firm called Gross Profit Margin. It is the proportion of Gross Profit to the Revenue. The equation of Gross Profit Margin could be written as:
Gross Profit Margin = [ (Revenue –COGS)/ Revenue ] *100
Taking our rubber plant example; assume that the firm made revenue of $60 m and COGS turned out to be $25 m. Then apparently, gross profit margin would turn up to be 58% (approx.). This means that for every dollar rubber firm earns on widgets, it really has only $0.58 at the end of the day.
Clever investors put more trust in this margin as it shows a durable competitive advantage. Higher the margin, higher is efficiency of the firm. I.e. firm with higher Gross Profit Margin can make higher profit, as long as long as it keeps its overhead cost in control. And those with lower margins indicate inefficiency to control its production cost.
Gross Profit Margin is also an indicator to the pricing strategy of firms. Firms with higher competitive advantage do not worry in pricing high. Microsoft, which has a consistent Profit Gross Margin of 79% sell its products at higher price than any other, still make a big profit. But those companies with lesser Profit Gross Margin and thus a lesser competitive advantage have to compete by lowering their prices which ultimately put down their profit margins and thus profitability.
In general, a firm’s Gross Profit Margin should be consistent. It should not fluctuate much from one period to another unless it has undergone larger changes which will possibly affect COGS or pricing policies. Investors mostly check consistency of margin even by taking a look on history of last decade before investing. And thus account keeping is of highly advantageous for firms to show its consistency in Gross Profit Margin and so the durable competitive advantage. Here comes the importance of accounting firms, like accounting firms in Singapore. Those accounting services Singapore also let the firms know about the availability of funds to pay additional expenses and future savings.