Tony works full-time as a computer repair technician who makes onsite repairs for individuals and small businesses. He says his gross profit margin is 94% because last year his total revenues were $100,000 and his expenses were $6,000. He is actually doing better than Microsoft. They talk about gross profit margins of 80%, says Tony.
What is wrong with Tony's estimate of his gross profit margin?
Gross Profit Margin in Service Industries:
Gross Profit Margin in service companies, sometimes referred to as Gross Services Margin, can be misleading if you don't account for all of the direct labor costs of providing the service.
Answer and Explanation:
In most cases, gross profit gives an indication of the underlying profitability of the goods or services a company provides. It is the profit that is generated after accounting for all costs directly associated with making and selling its products, or providing its services.
Tony's business is a service business (let's assume the $6,000 expenses were for parts and tools used in repair jobs). Thus the key direct input into his computer repair services is his time and expertise. Every repair job consumes some of Tony's time, and he has a finite amount of time available to provide services for his customers. The costs of Tony's precious time is not reflected in his gross profit margin calculation.
Tony's direct labor cost is based on his salary, plus the cost of his benefits (insurance, retirement plans, etc.) and employment taxes for his business (not his personal income tax, but the business' share of the employment tax). He can compute the hourly cost of his labor, and compare it to the average hourly rate he charges his clients. This would give him a much better of the true profitability of his services.
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from Financial Accounting: Help and ReviewChapter 5 / Lesson 17