5.1.2 Gross profit margin

The gross profit of a company is calculated by subtracting cost of sales from sales revenue. The gross profit margin indicates what percentage of sales revenue is left to pay operating expenses, finance costs and corporate tax after deduction of the direct costs associated with the production of goods or services.

Gross profit margin is calculated as follows:

Gross profit margin provides insights into the ability of management to earn profits from the company’s core operations. It shows how effective the management is in controlling the costs of production or other expenses directly linked to the production of goods and services. It also gives an indication of a company’s ability to set competitive prices for its goods and services. The companies having a higher gross profit margin have higher pricing power and can earn higher profit per unit of sales. A stable gross profit margin over the years suggests that the company is in good control of its costs and profitability. Such companies are considered more reliable and capable of dealing with adverse market conditions or fluctuations.

Gross profit margin may change owing to a number of factors. Changes in pricing of products and services will directly impact gross profit margin. If the company increases the prices for its products or services while the costs of production and sales volume remain constant, the gross profit margin will increase. Conversely, if owing to competitive pressures, the company decreases prices, gross profit margin will decrease. Changes in the costs of production will also directly influence gross profit margin. If the company negotiates better prices with suppliers and designs cost-effective production processes, it will result in an improved gross profit margin. Bad purchasing policies may result in inventories being sold at reduced profits (or even losses) and adversely affect gross profit margin. Inventory losses owing to theft or obsolescence also decrease gross profit margin. Changes in sales volume and mix of sales will also have a direct impact on gross profit margin. For example, sales of low margin products will result in decreased gross profit margin. Sales of goods on a large scale results in economies of scale and reduces costs of production, which positively influences gross profit margin.

Gross profit margin will vary across different business organisations depending on the nature of business. For example, the calculation of gross profit margins for manufacturing concerns is significant owing to the high level of direct costs associated with the production of goods (such as the cost of labour, raw materials and other production related expenses). On the other hand, the calculation of gross profit margins for financial and banking institutions is not as relevant and might not even be reported because they are not involved in direct production functions and instead focus on calculations of operating costs and operating profits. Similarly, gross profit margins of various products might be different for a single business as well. For example, the gross profit margin for Tesco Bank will be less significant and relevant compared to the gross profit margin for Tesco Groceries.

The gross profit margin for Remote Sensors Plc is calculated as follows:

The gross profit margin for 2025 indicates that 40.71% of sales revenue is available after payment of cost of sales and can be used to finance operating costs, interest and corporation tax.

It can be observed that in 2025, Remote Sensors Plc’s gross profit margin increased, which is a positive sign. However, there was a slight decrease in gross profit margin from 2023 (38.24%) to 2024 (37.28%). Even a small decrease in gross margin is not a good sign because it can have a significant negative impact on a company’s net income and internal management would almost certainly call for further investigation. Since Remote Sensors Plc is a manufacturer of electrical equipment, a reduction in gross profit margin might be caused by several factors such as:

• a change in the sales mix resulting in low-margin products being sold
• discounts offered to increase sales volume whilst compromising profitability
• an increase in the prices of materials whilst this increase has not been passed on to customers through an increase in sales price
• poor purchasing policies resulting in inventories being sold at a loss
• inventory losses caused by theft or value reduction.

Activity 3 provides you with an opportunity to practise calculating the gross profit margin and to understand the significance of changes in gross profit margin over time.