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How do the gross profit margin, profit margin and return on capital measure how profitable a business is?

Calculate and interpret the profitability ratios: gross profit margin, profit margin and return on capital

A focused answer to the O-Level Principles of Accounts outcome on profitability ratios. The gross profit margin, mark-up, profit margin and return on capital employed, with worked calculations and interpretation.

Generated by Claude Opus 4.89 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
Try this

What this dot point is asking

SEAB wants you to calculate and interpret the main profitability ratios: the gross profit margin, the profit margin and the return on capital employed. The central insight is that profitability ratios turn the income statement into comparable percentages, so a business can be judged against last year or against another business regardless of size.

The answer

Gross profit margin

This shows the profit made on trading, before other expenses, as a percentage of sales:

\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Sales}} \times 100

A higher margin means more profit on each dollar of sales. It is affected by selling prices and the cost of buying goods.

Mark-up

A related measure expresses gross profit as a percentage of cost of sales instead of sales:

\text{Mark-up} = \frac{\text{Gross profit}}{\text{Cost of sales}} \times 100

Mark-up is the percentage added to cost to set the selling price; margin is the slice of the selling price that is profit.

Profit margin

This shows the final profit, after all expenses, as a percentage of sales:

\text{Profit margin} = \frac{\text{Profit for the year}}{\text{Sales}} \times 100

If the profit margin falls while the gross margin holds, the running expenses have risen.

Return on capital employed (ROCE)

This shows how well the owner's investment is being used to generate profit:

\text{Return on capital employed} = \frac{\text{Profit for the year}}{\text{Capital}} \times 100

A higher ROCE means the capital is working harder. It is often compared with the return available elsewhere, such as bank interest.

Worked example

A business reports: sales $\$ 300,000 $; cost of sales$ \ $210,000$ ; profit for the year $\$ 36,000 $; capital$ \ $180,000$ . Calculate the four measures and comment.

Step 1: Gross profit and gross profit margin

Gross profit $= 300\,000 - 210\,000 = \$ 90,000 $. Gross profit margin$ = \dfrac{90,000}{300,000} \times 100 = 30%$.

Step 2: Mark-up

Mark-up $= \dfrac{90\,000}{210\,000} \times 100 = 42.9\%$ . The business adds about $43\%$ to cost to set its prices.

Step 3: Profit margin

Profit margin $= \dfrac{36\,000}{300\,000} \times 100 = 12\%$ . After all expenses, $12$ cents of each sales dollar is profit.

Step 4: Return on capital employed

ROCE $= \dfrac{36\,000}{180\,000} \times 100 = 20\%$ . Each dollar of the owner's capital generates $20$ cents of profit, well above typical bank interest, so the capital is working well.

Examples in context

Example 1. Diagnosing a profit fall. A shop's gross profit margin stays at $35\%$ but its profit margin drops from $15\%$ to $9\%$ . Because trading is unchanged, the cause must be higher running expenses (perhaps rent or wages). The two margins together point the owner straight to the problem, which a single profit figure would not.

Example 2. Is the capital working? An owner has $\$ 100,000 $tied up in a business earning a$ 4% $ROCE, while a bank deposit pays$ 3%$. The business barely beats the safe alternative for far more effort and risk. ROCE lets the owner weigh the business against other uses of the same money.

Try this

Q1. Sales are $\$ 50,000 $and gross profit is$ \ $20,000$ . State the gross profit margin. [2 marks]

Cue. Gross profit margin $= \dfrac{20\,000}{50\,000} \times 100 = 40\%$ .

Q2. Profit for the year is $\$ 24,000 $and capital is$ \ $120,000$ . State the return on capital employed. [2 marks]

Cue. ROCE $= \dfrac{24\,000}{120\,000} \times 100 = 20\%$ .

Q3. The gross margin is steady but the profit margin has fallen. State the likely cause. [1 mark]

Cue. Running expenses have risen, since trading profitability (the gross margin) is unchanged.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original7 marksA business reports: sales

\

200\,000

; cost of sales

140\,000

; profit for the year

\

30\,000

; capital

150\,000

. Calculate (a) the gross profit margin, (b) the profit margin, (c) the return on capital employed, each to one decimal place.

Show worked answer →

Gross profit $= 200\,000 - 140\,000 = \$ 60,000$.

(a) Gross profit margin $= \dfrac{\text{gross profit}}{\text{sales}} \times 100 = \dfrac{60\,000}{200\,000} \times 100 = 30.0\%$ .

(b) Profit margin $= \dfrac{\text{profit for the year}}{\text{sales}} \times 100 = \dfrac{30\,000}{200\,000} \times 100 = 15.0\%$ .

(c) Return on capital employed $= \dfrac{\text{profit for the year}}{\text{capital}} \times 100 = \dfrac{30\,000}{150\,000} \times 100 = 20.0\%$ .

Markers reward gross profit of $\$ 60,000 $, the three ratios with correct formulas, and the percentages$ 30.0% $,$ 15.0% $and$ 20.0%$.

Original5 marksA shop's gross profit margin fell from

40\%

32\%

this year. (a) Suggest two reasons for the fall. (b) Explain why a falling gross profit margin matters to the owner.

Show worked answer →

(a) Any two reasonable reasons, for example:

The cost of buying goods rose but selling prices were not increased to match.
Selling prices were cut (a discount or price war) to compete.
A change in the mix towards lower-margin products.
Theft or wastage of inventory increasing the cost of sales.

(b) A falling gross profit margin matters because the business is now making less profit on each dollar of sales before other expenses. If it continues, the business may not cover its running costs, threatening the profit for the year. It signals the owner to review pricing, suppliers, or stock control.

Markers reward two valid reasons and an explanation that a lower margin means less profit per dollar of sales, pressuring the final profit.