Gross Margin Ratio

It is a profitability ratio that compares a company's gross margin to its sales

The gross margin ratio, also known as the gross profit margin ratio, is a profitability ratio that compares a company's gross margin to its sales. It demonstrates how much profit dollar ratio a firm generates after accounting for the costs they paid for goods or services delivered to customers.

Gross Margin Ratio

Gross margin alone specifies how much profit a firm makes after deducting the costs from the revenue generated.

Understanding the Ratio

The ratio varies by firm and industry. It shows how much money a company makes after subtracting the expenses of items sold from revenue. 

It defines the firm's efficiency, which is why managers should keep a careful eye on the gross margin ratio since even a slight decrease might imply a dip in the company's overall profitability. 

Percentage

The fixed cost component is fully covered when sales volume grows, allowing additional sales to pass through as profit.

When sales volume is low, the ratio is likelier to be low, and it rises as the percentage of sales as unit volume increases. When the fixed cost component is small, the effect is less noticeable.

Ratio Understanding

The ratio shows how much each dollar sales the firm keeps in gross profit. 

Example: The ratio is 10%.

For every dollar of revenue earned, $0.1 is held, and $0.9 is credited to the cost of products sold. 

The leftover funds can cover general and administrative costs, interest, debts, rent, overhead, or dividends to shareholders.

What is The Difference Between Gross Margin and Net Margin?

Gross margin is concerned with the link between revenue and cost of goods sold; net profit margin considers all of a company's expenses. 

Businesses reduce COGS from net profit and associated margins and auxiliary charges, including product distribution, sales rep salary, other operational expenses, and taxes.

Formula

Gross Margin Ratio = (Revenue – COGS) / Revenue

Gross Margin = (Revenue – COGS) 

Revenue is the money gained through sales for a specific period. Because it might include discounts and deductions from returned products, it's also known as net sales. 

Additionally, revenue is sometimes referred to as the top line since it stands on top of the income statement. To compute net income, or the bottom line, costs are removed from revenue.

"Top Line" and "Bottom Line" are the terms used for Revenue growth or decline and Net income growth or decline, respectively Wikipedia.

COGS is the cost of goods sold and is subtracted from revenue to get the gross margin, which is then divided by the revenue to get the ratio amount.

Where,

  • Revenue is the total sales of goods and services related to the business's principal operations. It can be calculated from the price and quantity sold or estimated from the number of customers and average sales per customer account. 

Both methods have been illustrated below:

Revenue = No. of Units Sold * Average Price

or

Revenue = No. of Customers * Average Price of Services

  • Cost of Goods Sold (COGS) is the amount of money spent to produce the goods or perform the services that have been sold or provided over a particular period. It includes direct costs like raw material and labor and indirect costs such as factory overheads directly attributable to production. 

COGS for a manufacturing company with no factory overheads can be calculated as follows:

COGS = (Beginning Finished Goods + Opening Raw Materials + Opening Work in Progress) + Total Purchases - (Closing Finished Goods + Closing Raw Materials + Closing Work in Progress)

NOTE

The formula above does not consider the cost of labor or other direct overheads that are usually included in the COGS calculation. 

Example Of Gross Margin Ratio

A furniture store might sell a TV set for $1000. It costs $200 to make, yielding the retailer a gross profit of $800, equating to a gross margin ratio of 0.8 or 80%

Total product revenue: $1000

Total production costs: $200

Gross profit: 1000 - 200 = 800

Gross margin ratio: (1000 - 200)/1000 = 0.8 or 80%

Let's take a low gross profit margin example. Imagine the company is an accounting firm that audits other businesses. A single audit sells for $1000 and costs $800, yielding a gross profit of $200. The margin is 20%

Total product revenue: $1000

Total production costs: $800

Gross profit: 1000-800 = $200

Gross profit margin: = (1000-800)/1000 = 0.2 or 20%

What Does the Ratio Tell Us?

The gross profit margin ratio analysis is a financial health indicator for a firm. It informs investors how much gross profit a firm earns for every dollar of revenue. For example, a smaller margin compared to the industry average might suggest that a firm is underpricing. 

A more significant gross profit margin suggests that a business may earn a decent profit on sales if overhead expenditures are controlled. Conversely, if a company's gross margin shrinks, it may try to cut labor expenses or find cheaper material suppliers.

Alternatively, as a revenue-generating tactic, it may opt to raise prices. As a result, investors are more likely to pay a greater fee for a firm with a more considerable gross profit margin.

Disadvantages of Using Gross Margin Ratio in Your Analysis

Despite the widespread usage of gross profit margin ratios, many consider their drawbacks. The problem is that certain production expenses are not entirely changeable. 

Only direct materials, according to others, should be included because they are the only variable that changes in proportion to income. 

When this new gross profit margin is applied, all other relevant costs are transferred to the operational and administrative cost categories resulting in a more significant gross margin % than before.

Gross Margin Ratios in Various Industries

A low ratio may not always imply a poor performance. Comparing ratios within the same sector rather than between industries is more necessary. Because it works in a service business with low production costs, a legal service company, for example, claims a high gross margin ratio. 

On the other hand, an automobile manufacturing business will have a lower ratio due to higher production expenses. Therefore, the gross profit margin is the first of three primary profitability measures. 

The other two are:

The operating profit margin reveals a company's bottom line profitability after subtracting all of its expenses, including taxes and interest payments.

Net profit margin reveals the company's bottom line profitability after subtracting all of its expenses, including taxes and interest payments.

How To Increase the Ratio?

The ratio assesses a company's ability to sell its goods profitably. Thus, it is better to have a larger ratio.

Increase the figure in one of three ways:

1. Purchase inventory at a Lower Cost

If enterprises can receive a substantial buy discount or discover a less costly supplier while purchasing inventory, their ratio will rise since the cost of products sold will be reduced.

2. Increase the Price of Items

A larger ratio would arise from marking up products as selling them at a higher price. However, this must be done competitively; otherwise, the items would be too expensive, and the firm will lose clients.

3. Product Redesign

It is an excellent long-term choice to redesign items such that they employ less costly parts or are less expensive to manufacture. The notion of target costing may be applied to develop goods with predefined margins. A product is not made if a certain margin cannot be met.

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Researched and authored by Chadi Kattoua | LinkedIn

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