In this session on Profitability Ratios we shall look at the following:

- The Gross Profit Percentage
- The Operating Profit Percentage
- The Specified Expense/Revenue Percentage

### Profitability Ratios

Profitability ratios tell us about a company’s performance; its ability to turn sales revenue into profit, the relative amount spent on different types of costs, and the return that the company generates from the money it uses to fund its activities.

All of the profitability ratios that we shall look at on this course should be presented as percentages. Exam questions typically specify the number of decimal places should be used but if this is not the case, one or two decimal places will usually provide sufficient accuracy.

#### Gross profit percentage

The Gross Profit Percentage (also known as the Gross Profit Margin) measures the percentage of sales revenue left after the costs incurred in making the products sold, or delivering the services provided, are deducted. It is a measure of how efficiently the business converts sales into gross profit.

Alternatively, we can think of it as the percentage of sales revenue that will go towards paying the running costs of the business and in providing a return for the company’s providers of finance (i.e. its lenders and shareholders).

The Gross Profit Percentage formula is shown below.

**Quick questions**

1. A business’ sales last year were £198,000 and its cost of sales were £105,000. Calculate the gross profit percentage for the year to the nearest percentage

**Click here to reveal the answer**

Gross profit for the year was £93,000 (i.e. 198,000-105,000)

Gross profit percentage is 47% (i.e. 93,000/198,000)

## 2. A business’ sales are £591,500 and its gross profit percentage is 46%. Calculate the gross profit to the nearest hundred pounds

**Click here to reveal the answer**

Gross profit is £591,500 x 46% = £272,090, rounded to £273,100

## 3. A business made a gross profit of £22,000. If its gross profit percentage is 45% calculate the business’ sales to the nearest pound

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Sales: 22,000/45% = £48,889

## 4. A business’ cost of sales last year were £48,000. If the business made a gross profit percentage of 40% calculate the business’ sales for the year to the nearest pound

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If the gross profit percentage is 40% then the cost of sales must equal the remainder of sales, or 60%.

Sales are therefore, £48,000/60% = £80,000

#### Operating profit percentage

The Operating Profit Percentage (also known as the Operating Profit Margin) measures the percentage of sales revenue left after the costs incurred in making the products sold, or delivering the services provided and the running costs of the company are deducted. It is a measure of how efficiently the business converts sales into operating profit.

Alternatively, we can think of it as the percentage of sales revenue that will provide a return to the company’s providers of finance (i.e. its lenders and shareholders).

The Operating Profit Percentage formula is shown below.

## Quick questions

1. A business sales last year were £750,000. Its cost of sales was £341,000 and its incurred administration costs of £172,000.

Calculate its operating profit percentage

**Click here to reveal the answer**

Profit from operations is £237,000

Operating profit percentage is 237,000/750,000 x 100 = 31.6%

## 2. A business’ operating profit percentage is 12%. If it made an operating profit of £58,765 calculate its sales to the nearest pound

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Sales are 58,765/12% = £489,708

#### Illustrations of calculations

A company’s Statement of Profit or Loss and Statement of Financial Position are shown below.

The calculations of Gross Profit Percentage and Operating Profit Percentage are shown below. The numbers used in their calculation can all be found in the Statement of Profit or Loss.

**Gross Profit Percentage: 6,420/15,030 x 100 = 42.71%**

**Operating Profit Percentage: 1,750/15,030 x 100 = 11.64%**

#### Evaluating profit percentages

Different types of businesses and different types of products have different profit percentages. How then, do we determine whether the profit percentage we have calculated represents good or poor performance?

We will compare the ratio calculated against one or more types of comparator. For example, the ratio for a previous period, a competitor or a target.

It is usually good if a business’ profit percentage is **higher** than its comparator. For example, we might say that a company’s operating profit percentage of 20% is better than that of its competitor whose operating profit percentage is 16%. Similarly, if a company’s gross profit percentage was 55% in the previous year and 42% in the current we would say that the ratio has worsened.

Note: When commenting on ratios you should try to avoid terms such as “gone up” or “gone down”, “risen” or “fallen”, “higher” or “lower” as these do not tell the reader whether the company’s position or performance is good or bad. Instead, you should try to use qualitative terms such as “better” or “worse” or “improved” or “deteriorated” as these provide more information to the reader and does not assume that they understand the ratio being discussed.

#### Reasons why profit percentages change

Students often lose easy marks in exams when they are asked to provide possible reasons for a change in gross or operating profit percentages. Let’s illustrate this issue with the following example:

We can see that the above business’ gross profit percentage has improved from 30% to 33% but if students are asked to provide a possible reason for this improvement many will say it has happened because the company’s sales have increased over the same period. Whilst this answer *could* be true, it is not sufficiently detailed to gain marks.

If, in our above example, the Cost of Sales consists of variable costs, a change in the company’s Sales should not result in a change in the gross profit percentage (since Costs of Sales would then change proportionately as Sales change). Something else, must therefore be going on.

##### Gross profit percentage: reasons for change

- Changes to selling prices will result in a change in the gross profit percentage
- Changes to the portion of total sales that qualify for bulk or trade discounts will also result in a change in the gross profit percentage
- Changes to the costs of goods sold per unit will also result in a change in the gross profit percentage. These changes could be caused by:
- Changes to materials prices (perhaps due to changes to the availability of discounts)
- Changes to labour prices (including that caused by the use of more or less overtime)
- Changes in fixed costs or, changes to the number of units that the fixed costs are spread over

So, for our above example, the gross profit percentage may have risen because the company was able to increase its selling prices, or perhaps it was able to obtain greater discounts on its materials or the its Cost of Sales include many fixed costs which remained the same as Sales increased (thus spreading their cost over a larger number of sales).

##### Operating profit percentage: reasons for change

- Any changes that affect the gross profit percentage will also affect the company’s operating profit percentage
- Changes to the amounts spent on administrative overheads, or selling and distribution costs will also affect the operating profit percentage
- As many expenses falling into these categories tend to be fixed in nature, an increase in sales typically results in an improvement in the operating profit percentage whilst a decrease in sales typically results in a worsening of the ratio

**Quick questions**

1. The cost of one of a business’ raw materials has fallen due to new suppliers entering the market. What will be the likely effect of this on the business’ gross profit percentage and its operating profit percentage?

**Click here to reveal the answer**

As the business’ cost of sales is likely to fall this will have the effect of increasing, or improving, the business gross profit percentage

This will also have the effect of increasing or improving the operating profit percentage

## 2. A business’ insurance premium for its delivery vehicles has increased substantially. What will be the likely effect of this on the business’ gross profit percentage and its operating profit percentage?

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The increased insurance premium should have no effect on the business’ gross profit percentage (as it will not be recorded in its cost of sales) but will cause a reduction, or worsening, or its operating profit percentage (as this is calculated using profits after overheads such as delivery costs).

### Specified Expense/Revenue Percentage

A Specified Expense/Revenue Percentage ratio takes whichever expense is of interest to the user and expresses it as a percentage of sales revenue. It therefore looks at the portion of sales that the company spends on that particular expense.

The Specified Expense/Revenue formula is shown below.

## Quick questions

1. A business’ sales for last year were £1,648,260. If it administration expenses were £177,699 calculate the administration expenses/revenue percentage to two decimal places

**Click here to reveal the answer**

Administration expenses/revenue percentage is 177,699/1,648,260 x 100 = 10.78%

## 2. A business’ sales last year were £24,495,300. If its distribution costs/revenue percentage was 16.38% calculate to the nearest pound how much it spent on distribution costs

**Click here to reveal the answer**

Distribution costs were 24,495,300 x 16.38% = £4,012,330

#### Illustration

A company’s statements are shown below. The user of the statements wishes to calculate the Selling Costs/Revenue Percentage and the Administration Costs/Revenue Percentage.

**Selling Costs/Revenue Percentage: 1,880/15,030 x 100 = 12.51%**

**Administrative Costs/Revenue Percentage: 2,790/15,030 x 100 = 18.56%**

#### Evaluating Specified Expense/Revenue Percentages

It is usually good if a business’ Specified Expense/Revenue Percentage is lower than its comparator (e.g. lower than the previous year or a competitor) and bad if it is higher. Sometimes, however, a lower ratio may indicate that there is a potential problem for the business.

For example, let’s say that a business’ Advertising Expense/Revenue Percentage has fallen from 10% last year to 4% this year. This change could mean that the business is spending too little on advertising and this might damage the business’ sales in the future.

In order to judge performance we should therefore try to find out the reason for changes in overheads in order to ensure that they will not damage the business in the longer term.

### Question 1

A company’s statement of profit or loss and statement of financial position for the latest and previous years are shown below.

## a) Calculate, to two decimal places, the gross profit percentages for the two years

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Gross profit percentages

- Y/E 31/12/2020: 218,115/588,448 x 100 = 37.07%
- Y/E 31/12/2019: 184,413/525,120 x 100 = 35.12%

## b) State whether the gross profit percentage has improved or worsened from 2019 to 2020

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The gross profit percentage has **improved**

## c) Calculate, to two decimal places, the operating profit percentages for the two years

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Operating profit percentages

- Y/E 31/12/2020: 83,612/588,448 x 100 = 14.21%
- Y/E 31/12/2019: 79,930/525,120 x 100 = 15.22%

## d) State whether the operating profit percentage has improved or worsened from 2019 to 2020

**Click here to reveal the answer**

The operating profit percentage has **worsened**

## e) Calculate, to two decimal places the selling costs/revenue percentage for the two years

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Selling costs/revenue percentage

- Y/E 31/12/2020: 25,624/588,448 x 100 = 4.35%
- Y/E 31/12/2019: 13,458/525,120 x 100 = 2.56%

## f) State whether the selling costs/revenue percentage has improved or worsened from 2019 to 2020

**Click here to reveal the answer**

The selling costs/revenue percentage has **worsened**

### Question 2

A company’s statement of profit or loss and statement of financial position for the latest and previous years are shown below.

## a) Calculate, to one decimal place, the gross profit percentages and operating profit percentages for both years and state whether these ratios have improved or worsened over from 2019 to 2020

**Click here to reveal the answer**

Gross profit percentage:

- Y/E 31/12/2020: 868,090/1,576,500 x 100 = 55.1%
- Y/E 31/12/2019: 785,021/1,488,505 x 100 = 52.7%

The gross profit percentage has **improved**

Operating profit percentage:

- Y/E 31/12/2020: 279,726/1,576,500 x 100 = 17.7%
- Y/E 31/12/2019: 229,663/1,488,505 x 100 = 15.4%

The operating profit percentage has **improved**

## b) Calculate, to one decimal place, the administration expenses/revenue percentage for both years and state whether this ratio has improved or worsened from 2019 to 2020

**Click here to reveal the answer**

Administration expenses/revenue percentage

- Y/E 31/12/2020: 388,719/1,576,500 x 100 = 24.7%
- Y/E 31/12/2020: 377,809/1,488,505 x 100 = 25.4%

The administration expenses/revenue percentage has **improved**