Monday, September 4, 2017

Buy at 68% discount and sell at 65% discount doesn't imply 3% gross profit margin [COMPACTIDEA]

Learnt this from a guy named Pankaj [a CA] at his fireworks shop at the annual Diwali fireworks market at Dana Mandi, Ludhiana. He said the other shops are selling Cock brand fireworks at 60% discount thinking that since they're buying at 68% discount, they get 8% gross margin when they sell at 60% discount, and that this is the minimum that they need considering shop rental, interest cost, wastage, wages, other expenses, etc.

Wrong.

Buying a thing with basic price 100 at 68% discount means you bought it at 32. Selling at 65% discount means you sell at 35. Gross profit margin is 3/35, or 8.6%. So the >=8% gross margin that others are asking for is already there at 65% discount. So Mr. Pankaj gets all the sales and volumes he needs since he quotes the best price in the market, while the fools out there sit idle, continuing to quote 60% discount. What's more, these fools happily believe that Mr. Pankaj isn't making any money or maybe is selling at a loss. Amidst all this, mathematics has the last laugh.

*****

Similarly, some people think that if a bank borrows money at 4% interest rate per year [the current rate paid on savings accounts] and issues loan at 10%, then its gross margin is 6%. May not be true. One way to think about this is to forget that the entity in which the bank is dealing is currency/rupees itself. Just call it "goods". The bank borrows 100 rupees but let's just call it "goods" without specifying its value. It pays 4 rupees for one year for these goods and collects 10 rupees. So for the bank the cost of goods sold is 4 while "revenue" is 10. Hence on this trade the gross profit margin is 6/10= 60%.

But there seems to be a problem with the above way of thinking. What if it's a factory that borrows 100 rupees worth of steel [excluding interest cost, if any] and needs to pay 4 rupees for the borrowing cost? Selling this steel at 110 is sort of identical to the bank example, but in this case we'll calculate gross profit margin as 6/110= ~5.45%

Not wholly clear to me yet.

1 comment:

  1. I think the gross profit margin difference is because the amount we are paying in both the cases is taken differently (I think it should be taken same). When we say that bank borrows 100 rs at 4% interest per year, then I think we should not say that bank pays 4 rs. I think it should be Rs 104. Bank borrows Rs 100 for which it has to pay Rs 104 after one year. Similarly, after issuing a loan, bank earns Rs 110 . So the difference is Rs 6 on sale of Rs 110 (Which will give same margin as the steel case).

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