Historical versus Forecasted Gross Profit Margin
by Doc Rich
Although gross profit margin can be a very useful analytical tool, special care must be taken to distinguish between historical gross margin and forecasted gross margin, especially during periods of volatile prices and/or input costs. This distinction is especially important in the current economic environment of rapidly rising energy costs, transport expenses, and commodity prices.
Gross profit margin is simply gross profit (i.e., net sales minus cost of goods sold) divided by net sales. It is the markup between what a company pays for inputs (and the costs to transform raw materials into finished goods for a manufacturer) and the price it charges when selling its products. For example, a gross profit margin of 20 percent implies that a company earns gross profit of 20 cents on every dollar of sales.
Historical gross profit margin is calculated using data from the income statement. Forecasted gross margin depends on the most recent input prices and prices charged. Because an income statement includes multiple months (three months for quarterly statements; twelve months for annual statements) of historical data, margins calculated using income statement data can differ significantly from the margins on the most recent products sold. Since the current margin is most likely to be repeated next month, it is the best to use to forecast potential future performance.
To fully appreciate the importance of this difference, it is necessary to understand the nature of cost of goods sold (COGS). On an income statement, a company must assign a cost to every unit sold. If a company sells 200 units, then COGS represents the cost of 200 units. For a retailer, COGS is simply the cost paid for the products that are resold (at a markup = gross profit). For a manufacturer, COGS is the cost of raw materials plus direct labor wages plus allocated overhead (i.e., a proxy for the cost of facilities and equipment) used to convert the raw materials into finished goods.
Consider the following simple example showing the calculation of COGS and gross profit on a first quarter income statement for a retailer that sells a single product
Month Units Purchased on 1st of Month Cost/Unit
January 5000 units $100
February 5000 units $120
March 5000 units $150
Assume that sales during the quarter are 15,000 units at a selling price of $200 per unit (i.e., revenue = $3,000,000). Thus, the company must assign 15,000 units of cost. This amount is simply the cost of the units purchased during the time period. Here COGS would be:
(5000 x $100) + (5000 x $120) + (5000 x $150) = $1,850,000
Therefore, gross profit is $1,150,000 and the gross profit margin is 38.3 percent. However, gross profit on the most recently purchased units is $50 on every unit sold (i.e., $200 sale price minus cost of $150 per unit) for a gross margin of 25 percent. Forecasting future profit based on a margin of 38.3 percent will produce significantly different results versus a forecast based on a margin of 25 percent!
Existing inventory, different inventory valuation techniques (LIFO, FIFO or average cost), multiple products or inputs and/or different selling prices further complicate gross profit margin calculations.
The lesson here is to be sure that forecasts are based on the most current information as opposed to merely relying of historical data gleaned from financial statements.