The Philosophy of Gross Margin Analysis
Gross Margin is the difference between revenue and cost before accounting for certain other costs. Generally, it is calculated as the selling price of an item, less the cost of goods sold.[i] Gross margin ratio is the ratio of gross profit of a business to its revenue. It is a profitability ratio measuring what proportion of revenue is converted into gross profit (i.e. revenue less cost of goods sold).[ii]
Gross margin = net sales – cost of goods sold + annual sales return
Gross Margin (%) = (Revenue – Cost of goods sold) / Revenue
Gross Margin Percentage = (Revenue-COGS)/Revenue*100%
The Historical Usage of Gross Margin Analysis
A gross margin for an enterprise is its financial output minus its variable costs. The use of gross margins became widespread in the UK from about 1960, when it was first popularised amongst farm management advisers for analysis and planning purposes (Barnard and Nix, 1979). The gross margin per hectare or per head for crops and livestock can be compared with ‘standards’ (published averages of what might be typically possible in average conditions) obtained from other farms. Gross margins, however, should only be compared with figures from farms with similar characteristics and production systems.[iii]
Purpose of Gross Margin Analysis
Understanding gross margin can be challenging to new business owners, but it’s critical to knowing whether your business is efficiently producing products and growing at the pace you desire.[iv] The purpose of margins is "to determine the value of incremental sales, and to guide pricing and promotion decision." "Margin on sales represents a key factor behind many of the most fundamental business considerations, including budgets and forecasts. All managers should, and generally do, know their approximate business margins. Managers differ widely, however, in the assumptions they use in calculating margins and in the ways they analyze and communicate these important figures."[v]
Gross margin ratio measures profitability. Higher values indicate that more cents are earned per dollar of revenue which is favorable because more profit will be available to cover non-production costs. But gross margin ratio analysis may mean different things for different kinds of businesses. For example, in case of a large manufacturer, gross margin measures the efficiency of production process. For small retailers it gives an impression of pricing strategy of the business. In this case higher gross margin ratio means that the retailer charges higher markup on goods sold.[vi]
"Margin (on sales) is the difference between selling price and cost. This difference is typically expressed either as a percentage of selling price or on a per-unit basis. Managers need to know margins for almost all marketing decisions. Margins represent a key factor in pricing, return on marketing spending, earnings forecasts, and analyses of customer profitability." In a survey of nearly 200 senior marketing managers, 78 percent responded that they found the "margin %" metric very useful while 65 percent found "unit margin" very useful. "A fundamental variation in the way people talk about margins lies in the difference between percentage margins and unit margins on sales. The difference is easy to reconcile, and managers should be able to switch back and forth between the two."[vii]
Using gross margin to calculate selling price
Given the cost of an item, one can compute the selling price required to achieve a specific gross margin. For example, if your product costs $100 and the required gross margin is 40%, then
Selling price = $100 / (1 – 40%) = $100 / 0.6 = $166.67
Examples
Example 1: For the month ended March 31, 2011, Company X earned revenue of $744,200 by selling goods costig $503,890. Calculate the gross margin ratio of the company.
Solution
Gross margin ratio = ( $744,200 − $503,890 ) / $744,200 ≈ 0.32 or 32%
Example 2: Calculate gross margin ratio of a company whose cost of goods sold and gross profit for the period are $8,754,000 and $2,423,000 respectively.
Solution
Since the revenue figure is not provided, we need to calculate it first:
Revenue = Gross Profit + Cost of Goods Sold
Revenue = $8,754,000 + $2,423,000
Revenue = $11,177,000
Gross Margin Ratio = $2,423,000 / $11,177,000 ≈ 0.22 or 22%
Graphic Explanation of Gross Margin
Varied type of graphs can be used for expressing the result of gross margin calculations. The main philosophy, reaching the meaningful results and explanations for both current and comparative years. A significant point is presentation of the results and expectations. In the meantime, the reasult of our calculations can be compare with the industry’s yearly performance deliverables. In this sense, our next year/s’ projections easily compare with the industry’s projection reports for forthcoming periods. These projection reports should be taken as a reference from reliable sources such as state instute of statistics and chamber of commerces’ reports, etc.
- Summary Graph
The Graph presents to comparative results of Sales and COGS* between FY* 12 and FY 13.
It presents to gross margin changes according to end of month results.
This graph lets us to observe changes of COGS and gross sales in FY by months.
X values represent of net sales result by customers; Y axis shows percentage of gross margin and bubles than again related with percentage of gross margin.
- Gross Margin Graph
It presents to gross margin changes according to end of month results.
- Gross Sales Graph
- COGS Graph
This graph lets us to observe changes of COGS and gross sales in FY by months.
- Gross Margin by Customers
X values represent of net sales result by customers; Y axis shows percentage of gross margin and bubles than again related with percentage of gross margin.
*COGS: Cost of Goods Sold
*FY: Fiscal Year[i] http://en.wikipedia.org/wiki/Gross_margin
[ii] http://accountingexplained.com/financial/ratios/gross-margin
[iii] http://orgprints.org/8290/1/firth_margins_economic_analysis.pdf
[iv] http://smallbusiness.yahoo.com/advisor/understanding-computing-gross-profit-margin-210000734.html
[v] ^ Jump up to: a b c d e f Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey: Pearson Education, Inc. ISBN 0-13-705829-2. The Marketing Accountability Standards Board (MASB) endorses the definitions, purposes, and constructs of classes of measures that appear in Marketing Metrics as part of its ongoing Common Language: Marketing Activities and Metrics Project.
[vi] http://accountingexplained.com/financial/ratios/gross-margin
[vii] ^ Jump up to: a b c d e f Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey: Pearson Education, Inc. ISBN 0-13-705829-2. The Marketing Accountability Standards Board (MASB) endorses the definitions, purposes, and constructs of classes of measures that appear in Marketing Metrics as part of its ongoing Common Language: Marketing Activities and Metrics Project.
This post first appeared on Robert Kaiser's Blog | Understanding Body Armour, please read the originial post: here
