Gross profit and operating margin are two of the measures for figuring out how profitable a business really is. If the gross profit entry on the income statement is negative — the company reported losses — the operating margin should be negative too. If it isn't, the most likely explanation is an error in the calculation process.
Gross profit is sales revenue less cost of goods sold. The cost of goods includes:
- Materials used.
- Packaging costs.
- Utilities at the plant or warehouse where goods are made or stored.
These costs change according to the amount of the product the company makes and sells. Fixed costs which aren't affected by quantity — advertising, sales-staff salaries, insurance, rent — aren't included in the cost of goods sold.
Suppose a company selling a new cookie generates $500,000 in sales over the first quarter. The cost of goods sold totals $400,000, so the gross profit is $100,000. The gross profit margin is gross profit divided by sales. In this example, $100,000/$500,000 gives a margin of 20 percent.
If sales drop while costs stay constant, or costs spike up while sales stay steady, gross profit goes down. It's possible gross profit can end up negative. For example, suppose the company doubles prices on the cookie. Instead of increasing sales revenue, the hike turns off consumers and sales slump to $350,000. If costs stay the same, the gross profit is now -$50,000.
- Administrative costs.
- Office supplies.
On a company's income statement, operating income sits right below gross profit, near the top of the statement. If the company has $100,000 in gross profit and $75,000 in expenses, the operating income is $25,000. With a negative gross profit of $50,000, the operating income is -$125,000.
The operating margin is the operating income divided by revenue. If operating revenue is $25,000 and revenue is $500,000, that's a 5 percent margin. If the company cuts expenses so operating revenue is $50,000, the margin increases to 10 percent. The higher ratio is better, as it shows the company's revenue isn't eaten up by fixed expenses.
If sales drop to $350,000, with operating income at -$125,000, the margin is -35 percent.
- If a company runs on a cash basis, it only reports sales revenue when the money comes in. If it uses accrual accounting, then it can count revenue as soon as it's earned. For example, if a store orders $1,000 worth of cookies to sell, the cookie maker reports the revenue as soon as the sales is complete, even if the store takes two months to pay.
Negative and Positive
If you see gross losses instead of gross profits but the operating margin reads positive, go over the figures. The most likely explanation is that there's been an error in the bookkeeping. Another possibility is that you're looking at different periods — the gross profits for the quarter and the operating margin for the year, for instance.
It is possible for a negative operating margin to also show positive growth. Suppose the company has -$50,000 in gross profits and operating expenses of $75,000. In the next quarter, the gross profit doesn't change but the company cuts operating expenses to $40,000. The operating margin has improved from -35 percent to around -25 percent.