Profit Margin Versus Gross Profit Margin - Understanding The Difference

by samson Itoje

I recommend that you establish a business that sell products or services with potential for good Gross Profit Margin not just good profit margin.

What is the difference?

Well, profit margin simply expresses the profit to be made from selling the product or service without consideration for the expenses that may be incurred in making the sale possible.

On the other hand, gross profit margin takes into consideration the total sales made as well as the direct expenses incurred in generating the sale.

Expressed mathematically:

Profit Margin = Selling price - cost price

Alternatively . . .

Profit Margin = Total sales amount - total cost of acquiring the goods sold

Whereas . . .

Gross Profit Margin = Total sales amount - total cost of acquiring the goods sold - total expenses incurred while selling the goods

In simple words . . . profit margin taken alone gives a false sense of profit whereas gross profit margin gives a true picture of profit.

Gross Profit Margin And Business Opportunities

People are bombarded daily with business opportunities, both online and offline.

Proactive employees thinking of establishing a second income source through investing in a business opportunity are often at a loss what business opportunity to key into in view of the hundreds of business opportunities competing for their attention.

There are a number of factors to take into consideration when choosing a business opportunity to participate in. I simply ask that you include Gross Profit Margin Potential as one of the criteria in choosing a business opportunity.

Why?

Simple reason: thousands of entrepreneurs have lost their hard earned savings to businesses with low gross profit margin potential.

Believe me, their business story may have been different if they understood the relationship between gross profit margin and business sustainability before venturing into entrepreneurship.

Gross Profit Margin Analysis - A Case Study

The above might sound like meaningless theory to you. But I assure you it is not.

Let's consider one example to help you appreciate the point I'm making here.

Business Startup Example:

A friend of a friend noticed that a number of small scale groceries in his neighbourhood were making what he considered to be good sales.

After observing this business model for a while, it struck him that this could be a profitable business for his wife who at the time was unemployed. He discussed with her and she agreed with him that it was a good business idea.

They searched for a location, which they considered to be appropriate . . . a location they figured will generate good sales for them. They paid for it, cleaned it up, decorated it, stocked it with goods and then launched their mini supermarket.

Unfortunately, business did not go as envisage. Customers did not come in droves to shop as they hoped.

As days turned into weeks and weeks into month, it became obvious that the revenue from the business could not pay all of the expenses incurred in running the business.

Sadly, they were compelled to shut down the mini supermarket about a year after they opened for business. And when they reviewed their finances, they came to a realisation that they had lost over 50 percent of the capital they started with.

Impact of Gross Profit Margin On Business Sustainability

In the above example, the mini supermarket made some sales. But the profit margin was so small that it was not sufficient to cover the cost incurred in generating the sales.

In fact, the profit margin of supermarkets are often less than 5 percent.

Now, if the profit margin of a supermarket is about 5 percent, what do you think the gross profit margin will be?

Of course, far lower than 5 percent!

So, how do supermarkets survive?

Well, supermarkets have to do massive amount of sale to be able to cover all of their costs and turn profit. So, a small corner shop mini-supermarket won't do you a world of good as an entrepreneur.

Guess what.

The interest rate for commercial banks in country is 26 percent.

Now pause and think about that.

If you have a supermarket, how do you borrow loans at 26 percent interest rate to fund a business with 5 percent profit margin?

That will be disastrous!

Bottom line.

Gross profit margin potential is a key factor to consider when deciding what business opportunity you should invest in.

Gross profit margin is a better measure of the long-term profit potential of a business because it gives a clearer picture of the costs associated with selling whatever it is your business sells.

In addition, when you invest in a business with good gross profit margin, you can confidently access bank loans to expand your business because you know your business will generate enough cash flow to pay the laon principal and interest.

Of course, many small business people jump into business opportunities without consideration for the gross profit margin potential of these businesses. But you don't have to be like them.

Don't be like the couple mentioned above who lost a large chunk of their hard earned money in mini supermarket business.

Get the right financial education. And invest right.

P.S: Have a question or comment? Click the link below to post them.