The gross margin percentage is a calculation that shows the proportion of sales comprised of those costs directly related to either the goods sold or services rendered in order to generate sales. The percentage is closely monitored over time to see if a number of possible factors are impacting company profitability. If a business typically sells goods, then the gross margin percentage is calculated as:
If a business typically sells services, then the gross margin percentage is calculated as:
(Sales - (wages of billable staff + related payroll costs of billable staff)) ÷ Sales
For example, ABC International has sales of $1,000,000, direct material costs of $250,000, direct labor costs of $75,000, and $125,000 of factory overhead. This results in a gross margin percentage of 55%, which is calculated as:
($1,000,000 Sales - ($125,000 Overhead + $250,000 Direct materials + $75,000 Direct labor)) ÷ $1,000,000 Sales
It is customary to closely track the gross profit percentage over time, since a decline in it can signal any of the following problems:
- A decline in prices
- A change in the mix of products and services sold
- An increase in production costs
- An increase in bad debts
- An increase in charges for scrap and spoilage in the production process
- An increase in charges for obsolete inventory
A significant decline in the percentage is a strong indicator that the market is becoming more competitive, and that management should therefore begin to pare back on its selling and administrative expenses in order to avoid losses. A decline can also indicate that a customer is becoming too powerful, and so is demanding steep price discounts.
The gross profit percentage can yield misleading results for any of the following reasons:
- The cost of direct materials can vary, depending upon the cost layering method used (such as FIFO, LIFO, or weighted average costing).
- The cost of direct labor does not really vary with sales volume, since the cost of staffing the product line will probably stay the same, even if production volumes vary.
- The cost of factory overhead is largely fixed within general ranges of production volume.
Thus, some changes in the gross margin percentage may be caused by changes in the amount of fixed costs and the number of units produced, rather than any real costing issues that management can fix.
A variation on the gross profit percentage is the contribution margin percentage, which eliminates all fixed costs from the gross profit percentage calculation. With just variable costs included in the calculation, the contribution margin percentage tends to be a better measure of performance.