$1,120,000 of gross profit. Is that good?: In 2025 Lena's Bakery Ltd sold $1,600,000 of bread, cakes, lunches and wholesale orders. The flour, butter and packaging for all of it cost $480,000, so the gross profit was $1,120,000 (3.4.1).
Marco wants to know whether that is a lot. On its own, a dollar figure cannot tell him. A business ten times the size would make ten times as much without being any better at it.
The answer is to ask a different question: out of every dollar the customers paid, how much was left once the ingredients were paid for? That share, written as a percentage, is the gross profit margin (GPM).
Gross profit margin = gross profit ÷ sales revenue × 100
A figure that compares two lines of the accounts like this is a ratio. The ones that measure profit are the profitability ratios.
Lena's Bakery Ltd, gross profit margin, 2025
Find the gross profit
Sales revenue − cost of sales = $1,600,000 − $480,000 = $1,120,000.
If the table already gives the gross profit, use it. If not, this line is your working.
Divide by sales revenue
$1,120,000 ÷ $1,600,000 = 0.7
Times 100, with the % sign
0.7 × 100 = 70.00%.
Write the sign. A ratio that is a percentage is not finished without it.
What 70% means: Of every $1 a customer spends at the bakery, 70 cents is left after paying for the ingredients and packaging that went into what was sold. The other 30 cents is the cost of sales.
Those 70 cents still have to pay the wages, the rent and every other expense. The gross profit margin says how much room the bakery has to do that.
Two things move the gross profit margin: the price the bakery charges and the cost of sales for each thing it sells. Raise the price of a loaf with the flour cost unchanged, and more of each dollar is left. Pay Valley Grain more for the same flour, and less is. Wages and rent sit lower down the account, so they do not touch this ratio at all.
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From 70 cents to 5 cents: The 70 cents of gross profit in every dollar is not what the bakery keeps.
The night shift at Mill Lane, the counter staff in three shops, the rent, the electricity for the ovens and the vans all come out of it first.
In 2025 those expenses came to $1,035,000, and the profit before interest and tax was $85,000.
The profit margin asks the same question one line further down: out of every dollar of sales, how much is left once the expenses have been paid as well?
Profit margin = profit before interest and tax ÷ sales revenue × 100
The profit on top is the profit before interest and tax (PBIT): sales revenue − cost of sales − expenses. Some books call this ratio the net profit margin; it is the same idea.
Lena's Bakery Ltd, profit margin, 2025
Find the profit before interest and tax
Sales revenue − cost of sales − expenses = $1,600,000 − $480,000 − $1,035,000 = $85,000.
Divide by sales revenue
$85,000 ÷ $1,600,000 = 0.053125
Times 100, rounded to two decimal places
0.053125 × 100 = 5.3125, so 5.31%.
Round only at the end. 5.3% or 5% are the same answer rounded further; 6% is wrong.
The wrong profit on top: Accounts list several profits. Only one of them goes into the profit margin.
Profit before tax ($75,000) gives 4.69%. Profit for the period ($60,000) gives 3.75%. Both are wrong: interest and tax are taken off after the profit margin is measured. Use profit before interest and tax, $85,000, and the answer is 5.31%.
| Gross profit margin | Profit margin | |
|---|---|---|
| On top | Gross profit, $1,120,000 | Profit before interest and tax, $85,000 |
| Underneath | Sales revenue, $1,600,000 | Sales revenue, $1,600,000 |
| Lena's Bakery, 2025 | 70.00% | 5.31% |
| What moves it | Prices and the cost of sales | Prices, the cost of sales and every expense |
The gap between the two margins is the expenses. Out of the bakery's 70 cents of gross profit in each dollar, about 65 cents goes on expenses, most of it the $750,000 of wages and salaries for 22 people. A wide gap like this points at the running costs, not at the price of the bread.
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$700,000 is working for the bakery: Lena asks: for all the money tied up in the business, what did it earn in 2025?
The bakehouse at Mill Lane, its ovens and the vans were paid for with the money the owners put in and kept in, and with what is left of the bank loan.
That is return on capital employed (ROCE): the profit a business makes for every $100 invested in it for the long term.
ROCE = profit before interest and tax ÷ capital employed × 100
Capital employed is the long-term money the business uses: capital employed = non-current liabilities + equity. Both come off the balance sheet (3.4.2); the profit comes off the profit and loss account.
Lena's Bakery Ltd, ROCE, 2025
Find the capital employed
Non-current liabilities $350,000 (the bank loan) + equity $350,000 (share capital $200,000 and retained earnings $150,000) = $700,000.
Take the profit before interest and tax
$85,000, the same figure as in the profit margin.
Divide and times 100
$85,000 ÷ $700,000 × 100 = 12.142..., so 12.14%.
What 12.14% means: Every $100 of long-term money in the bakery earned $12.14 of profit before interest and tax in 2025.
The higher the ROCE, the harder the capital is working. Lena can set it against what the same money would cost to borrow, or earn in a bank, to judge whether the bakehouse was worth tying it up in.
Why profit before interest and tax? Part of the capital employed is the bank loan, and the interest is the bank's return on it. Taking the profit before the bank is paid measures what all the long-term money earned together, the owners' and the bank's.
Two slips cost the answer. Equity alone ($350,000) gives 24.29%, twice the true figure. Total assets ($760,000) is not capital employed either.
Lena wants the numbers higher: Marco reads the three ratios and asks the obvious question: how do we raise them?
Every ratio is a fraction, so there are only two ways
- Make the top bigger: the profit.
- Make the bottom smaller: the sales or capital it is measured against, without losing the profit.
Raise the gross profit margin
- Raise prices, if customers will still buy
- Buy ingredients more cheaply: a bulk deal or a cheaper supplier
- Cut waste, so fewer unsold loaves carry a cost with no sale
- Sell more of the products that carry the highest margin
Raise the profit margin
- Everything that raises the gross profit margin
- Cut expenses: cheaper energy, rent or insurance
- Use staff time better, so the same wages bake and sell more
- Drop costs that do not bring in sales
Raise the ROCE
- Everything that raises profit before interest and tax
- Sell assets it no longer uses and repay long-term debt
- Lease rather than buy, so less capital is tied up (3.2.4)
- Use the bakehouse more hours for the same capital
| Lena's Bakery, 2025 | Gross profit margin | Profit margin | ROCE |
|---|---|---|---|
| As it was | 70.00% | 5.31% | 12.14% |
| Cost of sales $32,000 lower ($448,000) | 72.00% | 7.31% | 16.71% |
| Expenses $20,000 lower ($1,015,000) | 70.00% (unchanged) | 6.56% | 15.00% |
| $50,000 of the loan repaid (capital employed $650,000) | 70.00% (unchanged) | 5.31% (unchanged) | 13.08% |
Read the table row by row. A saving on ingredients lifts all three ratios, because cost of sales sits at the top of the account. A saving on expenses leaves the gross profit margin where it was. Repaying debt changes only the ROCE, because it touches the capital, not the profit.
That is how to choose a strategy: first ask which ratio it moves, and why.
Every strategy has a price
- Higher prices may send customers to Goldcrust plc's bakery near Market Square (3.3.4), so revenue and profit can fall even as the margin rises.
- Cheaper ingredients may lower the quality that brings customers back.
- Cutting wages by cutting staff can slow service and lower morale.
- Selling assets raises ROCE only if the business does not need them later.
Name it, link it, cost it: A good answer names the strategy, says which ratio it raises, and then says what it might cost.
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How this comes up: It comes up as a calculation, from a table of figures about a business.
What it asks
- Calculate the gross profit margin, or the profit margin, for two marks with the working shown.
- Calculate the ROCE for one mark, often with no working required.
Pick the right two: The table usually holds more lines than you need: cash, stock, interest, tax. Part of the task is picking the right two.
The two-mark calculation
- Write the formula in words, for example profit margin = profit before interest and tax ÷ sales revenue × 100.
- Find the missing profit first if the table does not give it: sales revenue − cost of sales for gross profit, then − expenses for profit before interest and tax.
- Put the figures in, with $ and the units of the table ($m, $000s).
- Give the answer to two decimal places with a % sign. Round only at the end.
Three ways to lose a mark: No working. Where the question says show all your working, a bare correct answer gets one mark of two.
No % sign. 0.1211 or 12.11 without the sign loses the answer mark. The wrong profit. Profit before tax or profit for the period in place of profit before interest and tax gives a wrong answer.
Calculate Harbourside Cafés' profit margin for 2025 (show all your working).
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.