Profit Margin Ratio's and Break Even Analysis

Gross profit margin ratio

The gross profit margin ratio expresses the gross profit as a proportion of sales.

Note: gross profit is used to calculate the gross profit margin ratio

The gross profit margin ratio is used as one indicator of a business's financial health. It shows how efficiently a business is using its materials and labour in the production process and gives an indication of the pricing, cost structure, and production efficiency of your business. The higher the gross profit margin ratio the better.

Gross profit margin ratio = gross profit ÷ income

The gross profit margin is simply the gross profit margin ratio expressed as a percentage:

Gross profit margin (%) = (gross profit ÷ income) x 100

Larger gross profit margins are better for businesses

The higher the percentage, the more the business retains of each dollar of sales, which means more money is left over for other operating expenses and net profit.

A low gross profit margin ratio means that the business generates a low level of revenue to pay for operating expenses and net profit. It indicates that either the business is unable to control production and inventory costs or that prices are set too low.

Back to top

Net profit margin ratio

The net profit margin ratio is the net profit as a proportion of sales.

The net profit margin ratio shows the proportion of every dollar of sales that is left after all expenses have been paid, and remains as net profit.

Net profit is used to pay for interest, tax and distribution to the owners. The higher the net profit margin ratio the better.

Net profit margin ratio = net profit ÷ income

The net profit margin is simply the net profit margin ratio expressed as a percentage:

Net profit margin (%) = (net profit ÷ income) x 100

A high net profit margin ratio demonstrates how effective your business is at converting sales into profit. It may mean that you are capitalising on some competitive advantage that can provide your business with extra capacity and flexibility during the hard times.

A low net profit margin ratio may mean that you are not generating enough sales, the gross profit margin is too low, or that you are not keeping your operating expenses under control to leave an acceptable profit.

A decrease in the net profit margin ratio over time may indicate cost blowouts that require efficiency improvements. A business with a low ratio might need to take on debt to pay its expenses.

Back to top

Break even analysis

The break even point is the point at which income and expenses are exactly equal. The business has not made a profit or a loss, but you have recovered all business expenses.

Another way to look at it, is that at the break even point each unit you have sold has paid for itself (cost of goods sold (COGS) or variable costs) and contributed a share toward the total operating expenses (fixed costs or overheads) for the period.

The break even analysis is critical for any business owner, because you will know exactly when you begin to make a profit. The break even point is the lowest limit when determining profit margins. You will know how low a price you can offer, and the effects of discounting on your net profit.

You can calculate the break even for any period of time – a year, quarter, month, week, day – just make sure all three estimates relate to the same time period.

The formula used to calculate the number of units for break even:

Number of units =                         total fixed costs               
                                   (unit selling price - variable unit cost)

The formula used to calculate the value in dollars for break even:

Dollar value =                                total fixed costs            
                                   1 - (total variable costs ÷ total sales)

Fixed Costs

Fixed costs are paid whether or not you make any sales and are also known as business expenses, overheads, outgoings or operating expenses. Fixed costs do not vary in proportion to sales or production.

Variable costs

Variable costs vary directly with the volume of sales or production and are also known as the cost of goods sold (COGS), cost of sales, or direct costs of sales.

Semi-variable

Some costs are semi-variable, that is, they contain both a fixed component and a variable component. Semi-variable costs can be incurred without sales, but are affected by volumes of trade. For example, telephone charges have a fixed line rental component and a call charge component that will increase with increased sales.

For all practical purposes, a small business won't divide these semi-variable costs into fixed and variable components. Exactly how the cost is classified is not critical, but it will impact on your break even analysis. If you underestimate the variable costs (cost of goods sold) you will underestimate your break even point.

Back to top

What's next…

Back to top

 

Related Information

Business Tool to download:
Breakeven Analysis

Workshops

Our free Business Basics workshop will guide you through all the steps involved with establishing and running your own business.
Contact the Small Business Development Corporation Contact your local Small Business Centre
© 2014 Small Business Development Corporation (All Rights Reserved) Home | Privacy | Disclaimer | Copyright