There are certain parameters which tell us about the health of a business. Gross margin is also such an indicator of the profitability of a business. We will learn more about the ‘Gross Margin’ in this article.
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What is Gross Margin?
Gross margin, also known as gross profit or gross margin ratio, is a business parameter, which is obtained by deducting cost of goods sold (COGS) from the company’s sales, expresses as a percentage of sales. In other terms, it is total revenue of the company after subtracting cost of materials and labor, etc. You can also say that is a direct measure of profitability of the company. Higher the gross margin, higher the revenue available to fulfil the obligations of the company such as, taxes, debts, operating expenses, etc.
How to Calculate the Gross Margin?
Calculating, gross margin is a two-step process.
Example 1:
A company generated sales of $120 million in the last quarter. The cost of material and labor is $85 million. Determine the gross profit of the company using this data.
Revenue of the company= $120
COGS= $85
Gross profit of the company= $120- $85 = $35
Hence the gross margin of the company is 0.2926×100= 29.26%
Example 2:
What does a 26% gross margin indicate?
The 25% gross margin indicates that for every 100 dollars of revenue generated, $25 is retained as profit and $75 are attributed to cost of goods sold.
Different between the Gross Profit and Gross Margin
The gross profit and gross margin are not same. Although, both are the indicators of profitability of a business, there is a basic difference between both that while the gross profit is the absolute profit figures, the gross margin indicates the ratio. Gross profit is simply the difference between the company’s sales and cost of goods and the gross margin is the gross profit expressed as a percentage of sales.
Significance of Gross Profit in the Business
The gross profit is the indicator of profitability of a company. Gross margin gives insight into a company’s ability to control its production and operating costs, as lower the cost of production, higher will be the gross margin at same revenue.
Comparing gross margin of a company between different periods give an idea whether the company’s operations are becoming more or less efficient over the time. Another comparison can be made between various companies within a similar industry. The company’s having more gross margin are the once having more efficient operations and hence more profitability.
If you are an investor and want to evaluate a company for investment decisions, the gross margin may be helpful for you.
Limitations of Gross Profit
The gross margin is very useful indicator to evaluate a company, but at the same time, it has some limitations also. If you compare the companies across different industries on this parameter, you may not get the true picture. Some industries like manufacturing and mining, which are more capital intensive, often have high costs of goods sold, and hence, low gross margins, while the technology and software oriented industries, have low costs of goods sold and hence high gross margins.
How to Increase the Gross Margin of a Company?
The gross margin of a company can be increased by two ways:
Procure Material at a Cheaper Price
If you will procure materials at a cheaper price, then obviously the cost of goods will be less and the gross margin will be more as a result.
Sell Product at a Higher Price
Selling goods at a higher price is another way to increase the gross margins of your company. However, if you will keep the prices too high, the customers may not buy your products and hence the price should be competitive.
Conclusion
There are different parameters which evaluate the profitability of the company. Gross margin is just one of those parameters. Gross margin is obtained by deducting cost of goods sold (COGS) from the company’s sales, expresses as a percentage of sales. It gives an insight about how efficient a company in its operations. Comparing gross margin of a company between different periods give an idea whether the company’s operations are becoming more or less efficient over the time. Another comparison can be made between various companies within a similar industry. The company’s having more gross margin are the once having more efficient operations and hence more profitability. It has some limitations also. It may not give you clear picture if you compare the companies across different industries across this parameter. Some industries have high cost of goods and hence low gross margins while the others like tech industries have low cost of goods hand hence high gross margins. It is also a useful parameter for investors as they can use this parameter to evaluate the profitability of the company for informed investment decisions.
Also read: What is Net Present Value (NPV) and How Can It Help in Investment Decisions?
