Higher the gross profit margin, better the firm’s efficiency in managing its production expenses
Let us look at the computation of gross profit margin and its uses.
Investors need to make inferences about the gross profit margin (GPM)of the target firms for investment. Here’s how they can do it:
Profit and loss statement It is one of the three statements disclosed to the public by a public limited firm as per the requirements of GAAP. Firms report their quarterly and annual profit and loss statements on a regular basis. Let us look at the computation of gross profit margin and its uses. Suppose, there is a firm called Wesely Lakshay Ltd (WLL). WLL’s data for the quarter ending December 31, 2020 are (in Rs crore): Revenue from operations 800; cost of material consumed 200; purchase of stock in trade 20; change in inventories of FG & WIP (10); employee benefit expenses 50; finance costs 5; depreciation and amortization expense 12; other expenses 160 and total expenses 437.
Gross Profit Margin (GPM) It is computed by dividing the gross profit of a firm by its operating revenue for a specific period. Gross profit is calculated by subtracting cost of goods sold (CGS) from operating revenue of a firm in a specific period. Though one can pick the operating revenue form the P&L statement, the CGS figure is not explicitly reported.
Cost of Goods Sold (CGS) The CGS reveals the manufacturing /merchandising cost of the portion of goods that are sold. Hence, we may consider CGS as the sum of cost of material consumed, purchase of stock in trade, changes in inventories of FG and WIP, employee benefit expenses and depreciation and amortisation. We may exclude other expenses in the computation as it is usually the sum of all the expenses incurred in selling, general and administration functions of the firms. We ignore finance costs in the CGS head as it relates to the financial expense of the firms.
CGS for WLL for quarter ending December 31, 2020 = 200+20-10+50+12 = Rs 272 crore. And let us assume that the CGS for WLL for quarter ending September 30, 2020 is Rs 350 crore.
The GPM for WLL for quarter ending December 31, 2020 = (800-272)/800 *100 = 66%. and GPM for WLL for quarter ending September 30, 2020 if its operating revenue is Rs 900 crore = (900-350)/900 *100 = 61%. This indicates that the firm has improved its GPM such that its gross profit is Rs 66 for every Rs 100 of operating revenue in current quarter, and it is going up by Rs 5 in current quarter compared to the previous one. GPM should be used for manufacturing and trading firms as CGS is a major expense head for them. One may compare a firm either on its own historical GPMs or on comparison with that of its peers. Higher the GPM, better is the efficiency of a firm in managing its production/merchandising expenses.
The writer is associate professor of finance at XLRI- Xavier School of Management, Jamshedpur