Gross profit percentage is one of the few financial ratios that can be used to compare businesses across different industry sectors. It is primarily used as a way to compare and measure business models. In general, the higher the gross profit percentage, the better the business model. Another ratio analysts look at is the average operating expense as a percentage of gross profits. This is primarily looked at as a measure of operational efficiency.
Gross profit is defined as sales minus the cost of goods sold. Sales includes all revenue by company operations. The cost of goods sold, also referred to as COGS, includes the cost of assets used in generating total sales as well as the direct labor involved in creating the final product. It does not include any other operational costs of expenses of doing business such as rents or utilities. Analysts divide gross profit by total sales for a percentage that is used to compare business models across different companies.
Operating expenses are those expenses that are not directly connected to the costs of doing business. For instance, operating leases or rents cannot be directly connected to the production of any one item and so they are categorized as an operating expense. Other common operating expenses include salaries, travel expenses, phone and Internet expenses. One way in which analysts measure operational efficiency is to divide operational expenses by total sales. This ratio is referred to as operating margin. In general, the higher the operating margin, the better management is at managing operations.
In finance, it is not uncommon to find the average of different line items in order to make a calculation. This is to minimize the affect of anomalies from year to year. For instance, if operational expenses are $10,000 in one year and $20,000 in the next, an investment analyst will add both year one and year two together and then divide by two for the average. In this example, the answer is $10,000 plus $20,000 divided by two or $15,000.
Average Operating Expenses As A Percentage of Gross Profits Example
Assume a company had total sales of $100,000 with a cost of goods sold of $10,000. The gross profit is $90,000. Using the same example above, if average operating expenses are $15,000, then the average operating expense as a percentage of gross profits is calculated by dividing the operating expense by gross profit, or 16.7 percent. Analysts use this ratio much like they use operating margin, as a way to compare the operational efficiency of a company. The lower the percentage the better the company is at managing company assets.
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