Gross profit margin is the first benchmark of a business model. Business, failing to achieve maximization of gross profit margin, fails to move further as the business model itself is not economically viable. How to analyze and maximize the gross profit margin is a common question being asked by the entrepreneurs and businessmen.
Gross profit margin measures the initial margin of sales before deducting operating expenses such as selling and distribution, administrative, financing, taxes etc. A business is meant to earn profits. To avoid losses and earn sufficient profits, the gross profit margins need to be maximized to cover all the other operating expenses and still leave a margin for the owners of the capital.
It is essential to achieve good gross margins as high as possible. For achieving and sustaining those margins, careful analysis of the margins are required to find out internal reasons even when the margins are high.
How to analyze and maximize the Gross Profit Margins?
To improve the gross margins, first, we need to analyze them for the cause.
Reasons of Higher Gross Profit Margin (GPM)
- Efficient Management: An efficient and effective management of the processes may genuinely lead to higher GPM. Gross profit margin is very dynamic and may change every year. In such a situation, with a good gross profit margin in a particular year, management cannot sit and wait for gross margins to decline. A close watch has to be kept to sustain such margins for future.
- Low Cost of Production: If the production cost is reduced by introducing new and improved techniques, the gross margin may improve which is a good sign of profit maximization, future sustainability and growth. Maintaining the new and improved techniques is also very important. In the absence of proper maintenance, the gross profit margins in the future years may decline.
- The increase in Sales Price: Increase in the price of the product would directly impact gross margin. It is a good performance of management only if the management has achieved the higher prices because of the introduction of new features and improved quality of the product. If the prices are driven by the economy, there is no role of management and economy may move in the other direction also in the future and therefore, the management should be ready for the downside economy.
- Valuation of Stocks: This is a very sensitive point. Overvaluation of closing stock or undervaluation of opening stock may easily show a higher percentage of gross margin. This is not a genuine business tactic to maximize gross margin but a misrepresentation of facts. Owners and investors should always focus here to discourage such practices.
Reasons for Lower Gross Profit Margin (GPM)
Lower gross profit margin is the bad sign for any business and it calls for a very extensive and careful analysis. Various reasons for lower GPM may be:
- Higher Cost of Production: Higher cost of production directly throws light on the inefficient management of raw materials, labor etc. The problem may also lie in the utilization of current and fixed assets at the same time. The hurdle has to be figured out first. If the hurdle is found to be the higher cost of labor, the management may think of shifting the plant to a different location provided it is economically feasible. Similarly, other factors need careful examination.
- Lower Selling Price: The objective of maximization of gross profit margins can be significantly suffered by lower selling price. Now, lower selling price may be a reason of low quality of products. The quality needs to be focused and improved to regain the gross profit margins. The other uncontrollable reasons may be severe competition and lack of demand. These situations call for innovation in terms of new products and innovative selling techniques or better services.
- Change in Product Mix: If a firm is selling more than one product and by obvious reasons, all of them will have different selling prices and different margins. If the product with lower margin is sold more, the overall gross profit margin would be affected. At times, the mix of selling the products needs to be focused on to manage the levels of gross profit margin.