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Gross profit margins explained

Article by Melanie

Don’t know margins from margarine? Then make this article your bread and butter.

We promised a closer look at the topic of gross profit margins in our review of small retailers last issue. It’s a fascinating and important topic to explore and one that’s particularly pertinent to those who own retail stocks. And who better to introduce the topic than the world’s greatest investor, Warren Buffett?

If you head to http://www.borsheims.com and click on the ‘customer services’ tab at the top of the page, you’ll then see a ‘Warren E. Buffett’ link down the right hand side. Follow that link and you’ll find an interesting lesson on jewellery retailing. Here’s an excerpt that steps through the concepts of gross profit, operating costs and pre-tax profit (pardon Buffett’s American spelling, apparently he doesn’t know any better–Ed):

‘In order to establish a selling price for his merchandise, a jeweler must add to the price he pays for that merchandise both his operating costs and his desired profit margin. Operating costs seldom run less than 40% of sales and often exceed that level. This fact requires most jewelers to price their merchandise at double its cost to them or even more. The math is simple: Jewelers charge for merchandise that has cost them 50 cents. Then, from their gross profit of 50 cents, they typically pay 40 cents for operating costs, which leaves 10 cents of pre-tax earnings for every of sales. Taking into account the massive investment in inventory, the 10 cent profit is adequate but far from exciting.’

Mark-ups and margins

In our experience, many retailers think and talk in terms of their ‘mark-up’ percentage, as opposed to their ‘gross margin’, but it’s just a different way of expressing the same thing. If a retailer purchases an item for and sells it for 0, the mark-up would be 150% (the 0 selling price less the cost of sales–giving a gross profit of –divided by the cost price). The gross margin would be 60% (the 0 selling price less the cost of sales–giving a gross profit of –divided by the 0 sale price). It’s crucial to be clear, though, which of the two you’re talking about–confusing them can be very dangerous.

About the Author

Visit The Intelligent Investor for the rest of this article on gross profit margins and to find out more about share prices.

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