A retailer’s gross profit rises from $4,000 to $5,000. That sounds like a stronger month. Revenue, however, rises from $10,000 to $15,000. The shop keeps fewer cents from each dollar sold after the cost of the goods sold. A dollar subtotal and a percentage answer different questions.
Calculate both from the same statement
Gross profit is revenue minus cost of sales. In the first fictional month, $10,000 in revenue less $6,000 in cost of sales leaves $4,000. Divide the $4,000 by $10,000 to get a gross margin of 40%.
In the second month, $15,000 of revenue less $10,000 in cost of sales leaves $5,000. The gross margin is $5,000 divided by $15,000, or about 33.3%. Gross profit rose by $1,000 while gross margin fell by about 6.7 percentage points. Each additional dollar of sales need not yield the same gross profit as the earlier sales.
Look for the reason in the mix
A retailer might sell a larger share of lower-margin items. It might discount a product, or suppliers could charge more. The two totals show the change in outcome. Identifying the cause requires the sales mix, selling prices and costs or an explanation in the company’s report.
For example, imagine a shop that sells two fictional products. One yields 50 cents of gross profit per dollar, the other 20 cents. If the second product contributes a bigger share of revenue, the overall gross margin can fall even while both products keep their own margins. The total is weighted by the dollars of sales each product contributes.
Keep reading below the subtotal
The SEC’s statement guide shows operating expenses below gross profit, followed by items such as interest and taxes on the way to net income. If the second month’s selling and administration costs rise by more than $1,000, the gain in gross profit may be used up before the business gets to its operating result.
Compare the same periods and check which costs each company includes in cost of sales. An income statement can provide the starting point. The notes and management’s explanation can show whether a change reflects pricing, costs, mix or a difference in how the figures were prepared.
Sources & further reading
- SEC income statement guide
Shows revenue, costs of sales and subsequent expenses in a worked statement.
- SEC beginner’s guide to financial statements
Explains how the major financial statements describe different parts of a company’s finances.