ZIMSEC O Level Principles of Accounts Notes: Profitability Ratios

  • So we have already introduced you to accounting ratios
  • These ratios include a group of ratios that are known as profitability ratios
  • Such ratios measure how well a business performed in profit terms in a given period
  • At this level you are required to know how to calculate three profitability ratios:
    1. Markup
    2. Margin
    3. Net Profit (percentage)
  • As shown by the Income Statement (and Trading and Profit and Loss Accounts) there are two major types of profit:
    1. Gross Profit i.e. Sales (Net Turnover) – Cost of Sales and
    2. Net Profit i.e. Gross Profit – Operating Costs
  • Traditionally markup and margin are calculated using Gross Profit
  • For this reason they are often called gross profit margin and gross profit markup

Markup

  • Is the amount added to the cost of an item to obtain its selling price
  • Markup= Selling Price-Cost of Sales
  • As you can tell markup is usually similar to Gross Profit
  • Markup as a ratio is calculated using the formula:\mathrm{\frac{Profit}{Cost \quad of \quad Sales}}
  • For example a business has:
    1. Sales of 10 000
    2. Cost of Sales 8 000
  • In a given period
  • Calculate the markup:
  • Gross Profit = $10 000- $8 000
  • $2 000
  • Markup= \frac{2 000}{8 000}
  • \frac{1}{4}
  • Typically markup is expressed as a fraction in its lowest terms or as a percentage
  • In the above example the markup will be:
  • 25%
  • Bear in mind that markup can be calculated either for entire sales or for each unit

Margin

  • This is when profit is expressed in terms of the selling price
  • It is calculated using the formula:
  • \mathrm{\frac{Profit}{Sales}} alternatively this can be expressed as
  • \mathrm{\frac{Profit Per Unit}{Selling Price}}
  • In the above example the margin would thus be:
  • \frac{2000}{10000}
  • \frac{1}{5}
  • In percentage terms this would be:
  • 20%

Relationship between Markup and Margin

  • Because they are essentially derived from the same forumulae and items
  • There is a relationship between markup and margin
  • When given the margin \frac{1}{x} markup can be calculated using the formula:
  • \frac{1}{x-1}
  • For example if the margin is \frac{1}{5}
  • The markup would be:
  • \frac{1}{5-1} i.e.
  • \frac{1}{4}
  • Conversely given the markup \frac{1}{y}  the margin can be calculated as a formula:
  • \frac{1}{y+1}
  • For example if the margin is \frac{1}{4}
  • Then the markup would be:
  • \frac{1}{4+1} i.e.
  • \frac{1}{5}
  • You should be mindful of this relationship when it is needed e.g. during accounting using incomplete records

Net Profit Percentage

  • This is when the net profit is expressed in terms of Sales
  • It is sometimes known as Net Profit Margin for obvious reasons
  • The ratio is expressed and presented in percentage terms
  • The formula is: \mathrm{\frac{Net Profit}{Sales} x \frac{100}{1}}
  • For example a Business had Sales of $25 000 and a net profit of $5 000 calculate the Net Profit Percentage
  • \mathrm{\frac{5000}{25000} x \frac{100}{1}}
  • 20%

Where to get the figures/amounts

  • Profitability ratios as already pointed out involve the analysis of profit figures
  • Figures/Amounts used in the calculation of these ratios can be obtained from Income Statement/Trading and Profit and Loss Accounts

To access more topics go to the Principles of Accounting Notes.

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