Introduction to the gross margin ratio-
The gross profit margin is also known as A Gross margin. It is a financial metric that indicates how efficient a business manages its operations. It is a ratio which indicates that performance of a company’s mainly sales based on the efficiency of a production process.
Gross profit margin is a valuable financial measurement to company managers and company investors since it indicates the efficiency of producing and selling one or more products before extraneous costs are deducted.
The gross profit margin is based on the company’s Cost of goods sold. We can compare it to the operating profit margin and net profit margin depending on the information you want. Like other financial ratios, it always be only valuable if we found any inputs into equation are basically to be found correct.
What is the Gross margin ratio?
Gross profit margin is a type of financial ratio used by managers to assess the efficiency of the production process for a product sold by the company or for more than one product.
A business can be or maybe more efficient at producing and selling one product than another. It can calculate gross profit margin for each product as long as the business can differentiate the direct costs from the others.
The Cost of goods sold any company’s shows a income statement accounts for the direct costs are basically producing their products.
Direct costs normally include those specifically tied to a cost object, a product, a specified department, or even a project.
The Cost of goods that are sold can be made up of the company’s direct costs. Only direct costs are basciallly considered and not a indirect costs. These variables can cost change with the quantity of the product which is produced.
Examples are direct labour which includes the work done by the workers just on one particular product. Another direct cost is also direct materials that may include the raw materials needed to produce the product.
By this, we can understand the gross profit margin at the early stage if it is expressed as a financial ratio, like:
- Normally, the Cost of goods that are sold can be compared to the company’s net sales.
- Net sales, taken from the company’s income statement, are the total sales of less than any returns.
- The Cost of goods sold, which can also take from the income statement, are the direct costs of producing the company’s product or products.
Only firms that manufacture their products can have direct costs, and, as a result, the Cost of goods can be sold on their income statement. Companies that sell a service will typically have a very low or no cost of goods sold.
Like any other financial ratio, the gross profit margin can be only meaningful on a comparative basis. The financial manager might want to use trending analysis for comparing the gross profit margin to other periods or industry analysis compared to other similar companies.
What does the gross margin ratio tell you?
If a company’s gross profit margin is wildly fluctuating, this may signal poor management practices and inferior products. On the other hand, this may justify such fluctuations when a company makes sweeping operational changes to its business model.
In this case, temporary volatility should be no cause for alarm.
For example, suppose a company decides to automate certain supply chain functions. In that case, the initial investment may be high, but the Cost of goods ultimately decreases due to automation’s lower labour costs.
Product pricing adjustments can also influence the gross margins of the company. If a company has started selling its products at a premium, it has a higher gross margin, with all other things equal.
But this can also be a delicate balancing act because if a company is setting its prices overly high, fewer customers may buy the product. The company may consequently haemorrhage market share.
Formula and Calculation of Gross margin ratio-
GROSS MARGIN = TOTAL REVENUE – COST OF GOODS SOLD / TOTAL REVENUE
While calculating the gross profit margin, it has only two variables:
Net sales and Cost of goods sold.
It can take both numbers from the income statement of the company:
Net sales or net revenue can be used in the equation because Total Revenue cannot be accurate. You can subtract any returns, discounts, and allowances from Total Sales to arrive at the net figure.
Cost of Goods Sold-
Cost of Goods Sold is the total of the production costs of a company’s product. It also includes the direct costs of producing the product, like direct materials and direct labour. Indirect costs are basically not included in any calculation. There is some room for variability in what costs calculate the Cost of goods sold. It can also vary with the industry in which the company is operating. General company expenses like sales and administrative costs, marketing costs, and most fixed costs are not included in the goods sold.
Example of using Gross margin ratio-
Analysts normally use gross profit margin to compare a company’s business model with that of its competitors.
For example, let’s assume a Company ABC and a Company XYZ both have produce widgets with an identical characteristics and any similar levels of quality.
Suppose Company ABC finds a way to manufacture its product at 1/5 the Cost. In that case, it will command a higher gross margin because of its reduced costs of goods sold, thereby giving ABC a competitive edge in the market. But then, to make up for its loss in gross margin, XYZ counters by doubling its product price as a method of bolstering revenue.
Unfortunately, this type of strategy may backfire if any customers become a deterred by any higher price tag, in which may be case, XYZ loses both gross margin and any type of market share.
Analysis of gross margin ratio
The gross margin ratio is a type of profitability ratio that helps measure how profitable a company can sell its inventories.
It only makes sense that makes higher ratios are more favourable. Higher ratios can mean that the company is selling their inventory at a higher profit percentage.
There are two ways for achieving a high-profit margin. There is one way to buy very cheap inventories. If retailers can get any big type of purchase discount when company buy their inventory from a manufacturer or any wholesaler, when you see gross margin that will be higher may be because their costs are basically down.
The second way of retailers can be achieve at a high ratio is by just marking their goods up by higher. It has to be done competitively; otherwise, goods will be too expensive, and customers will shop elsewhere.
A company with a high gross margin ratio mean that the company will have more money to pay operating expenses like salaries, utilities, and rent.
Since this ratio measures the profits from selling inventory, it also measures the percentage of sales that can use for helping fund other parts of the business. Here is another great explanation.
Disadvantages of analyzing gross margin ratio-
As we always stay curious to know about the advantages of any topic, this time, let’s see about the disadvantages of the gross margin ratio below:
Many companies see gross profit margin disadvantages despite using the gross profit margin ratios. But the issue is that certain production costs are not entirely variable.
Some believe that should include only direct material as they are the only variable to change in proportion to revenue.
When we applied new type of gross profit margin that will causes any transference of all type of other related costs to a operational and by administrative Cost categories. It tends to cause a higher gross margin percentage than originally. Certain type of industries and where businesses apply it instead of any more common application.
What is a good gross profit margin ratio?
To know what can be a good gross profit margin ratio, let’s see below two points for better understanding:
GROSS PROFIT MARGINS WHICH ARE SPECIFIC FOR AN INDUSTRY-
A high-profit margin outperforms the average for its industry. According to the Houston Chronicle, clothing retail profit margins ranged from 4 – 13% in 2018.
It means that any business is doing exceptionally well with an 18.75% gross profit margin. This business can be a model for other companies to follow.
However, this store can be a prime tourist location, and charges can be applied as a heavy premium for the company’s clothing. Those high prices can also directly affect the company’s gross profit margin.
GROSS PROFIT MARGINS CAN ALSO BE LOWER FOR A STARTING UP A COMPANY-
Profit Margins for a starting up are generally lower because the operation is brand new, and it typically takes a while for efficiencies to be developed. However, if an experienced person was a clothing manufacturer, the start-up company knew many of the tricks for trading before starting the business.
Regardless, there are possible ways that the start-up company can improve its efficiencies and perhaps later realize even higher profits. Lately, the company have been thinking of expanding its line of clothing too.
First, the company needs to consider whether or not spending more money on labour and even manufacturing for providing these new products will still also give the company the profit margin that the company is currently enjoying.
The company may also want to consider producing a small new batch of the new clothing and analyzing how those items are selling in the first place. If the new line works, then later run the numbers to determine if the new clothing lines will be permanent additions.
Good Margin ratio Vs. Bad margin ratio-
Small business owners can also interpret their company’s financial ratios.
Here are the some of interpretations of gross profit margin ratio.
Company Production Efficiency
Gross profit margin is used for measuring the efficiency of a firm’s production process. A good or a higher percentage of gross profit margin is very indicative for a company by producing its product more efficiently. The financial manager can compare the gross profit margin to companies in the same industry or across periods for the same company.
Lower Efficiency in the Production Process
Lower a percentage of gross profit margin is very indicative of a company by producing their type of product not by just quitting as efficiently. It will be determined if the gross profit margin is dropping across time or lower than companies in the same industry.
A low sales volume might not cause the gross profit margin also to look low. However, if sales volume is not enough to cover other company expenses such as sales and administrative expenses, it doesn’t matter what the gross profit margin is.
Poor Pricing Structure
A poor pricing strategy can cause gross profit margin to come in low.
How to increase the gross margin ratio?
This ratio measures how profitably a company can sell its inventory. A higher ratio is more favourable. There are typically two ways for increasing the figure:
Buy inventory at a lower price-
If companies get its large type of purchase discount when they about to purchase any inventory. Find a less expensive type of supplier. Their ratio will be increase because the Cost of goods that are sold will be much lower.
Mark up goods-
Marking up goods that are sold at a higher price would result in a higher ratio. However, they must do this competitively – otherwise, the goods would be too expensive, and fewer customers would purchase from the company.
Gross margin ratio for different industries-
A low gross margin ratio necessarily does not indicate a poorly performing company. It is important for comparing ratios between companies in the same industry rather than having comparisons across industries.
For example, a legal service company usually reports a high gross margin ratio because it also operates in a service industry having low production costs. In contrast, this ratio can be lower for a car manufacturing company because of its high production costs.
By considering the gross margin ratio of McDonald’s at the end of 2016 was 41.4%. The ratio of the Bank of America Corporation by the end of 2016 was 97.8%.
Comparing these two ratios will not be provided by any meaningful insight into how profitable McDonalds or the Bank of America Corporation is. But let’s compare McDonald’s and Wendy’s (two companies operating in the fast-food industry). We can also get an idea of which company is enjoying the most cost-efficient production.
Gross profit margin is considered as the first of the three major profitability ratios. The other two are operating profit margin helps in indicating that how operationally efficient a company’s management is, and net profit margin, which also reveals its bottom-line profitability after subtracting all expenses. which is including taxes and a interest payments.
Frequently Asked Question-
What is the gross margin ratio?
The gross margin ratio is considered as a profitability ratio that helps in the comparison of the gross margin to the net sales. This ratio will be measures on how profitable a company will sells its merchandise or inventory.
In other words, mainly a gross profit ratio is a essentially the percentage a markup on any merchandise from a Cost. It is basically pure profit that get from sale of inventory that may can go to by paying its operating expenses.
The gross margin ratio is often get confused with a profit margin ratio. But these two ratios are completely well different.
The gross margin ratio only considers the Cost of goods sold in its calculation because it measures the profitability of selling inventory. The profit margin ratio, on the other hand, considers other expenses.
How to calculate the gross margin ratio?
The only data you will need to calculate the gross margin ratio is your total revenue, and the total Cost of goods are sold for the month (or whatever time frame you’re calculating your ratio for).
This formula for calculating gross margin ratio % ratio is simple:
GROSS MARGIN % = TOTAL REVENUE – COST OF GOODS SOLD / TOTAL REVENUE * 100
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