Gross margin refers to the percentage of a company’s revenue that it retains after accounting for the Cost of Goods Sold or COGS.
While both gross profit and gross margin connote the same thing, which is the retention of revenue after netting it against COGS, they serve different purposes. Gross margin lends the objective knowledge of how much a company can retain against Re.1 of its revenue.
A company may use this retained profit to finance other operations, mitigate debts and other liabilities, and also distribute dividends. Gross margin, therefore, somewhat portrays a company’s financial health.
Also, if studied across periods, it presents a more concrete view of a company’s profitability and management. It also facilitates comparison between companies with varying market capitalisation.
How to Calculate the Gross Margin?
As mentioned earlier, gross margin denotes the net sales that a company keeps after deducting the Cost of Goods Sold. COGS refers to the costs directly associated with the production of goods or rendering of services.
Therefore, the Cost of Goods Sold includes production expenses, labour charges, inventory maintenance costs, costs of acquiring raw materials, etc.
It is calculated as, COGS = [(Cost of inventory at the beginning of accounting period + Purchases) – Cost of inventory at the end of an accounting period]
Let’s assume that Company CBA recorded inventory worth Rs.2 lakh on 1st April 2019. It further made purchases worth Rs.2.5 lakh during the year ending 31st March 2020. On 31st March 2020, its records showed inventories worth Rs 3.5 lakh.
Therefore, cost of the goods it sold in FY 19 – 20 is equal to Rs.1 lakh [(200,000 + 250,000) – 350,000).
The net sales amount, on the other hand, is calculated after netting the gross sales amount against returns, discounts, and allowances.
Assume Company YZA has recorded gross sales worth Rs.2 lakh in one accounting period. Against such sale, it also recorded returns worth Rs.15,000 and allowed a 10% discount on a sale of Rs.10,000.
In this case, discount allowed equals to Rs.1000. Hence, net sales = Rs. (200,000 – 15000 – 1000) = Rs. 184000.
In case there have been no sales returns, discounts, or allowances on sales, then the gross sale equates to net sales.
Nevertheless, the gross margin formula is expressed below:
Gross Margin = (Total Revenue – Cost of Goods Sold) / Total Revenue
Or, it could also be written as Gross Margin = Gross Profit / Total Revenue
Gross margin is always denoted in percentage terms.
Example: The income statement of Maruti Suzuki India Limited showed a total revenue amount and cost of revenue of Rs.85,45,73,000 and Rs.64,14,37,000 respectively on 30th March 2019.
Therefore, its gross profit would be Rs. 21,31,36,000 (854573000 – 641437000).
Ergo, the gross margin rate of Maruti Suzuki for the Financial Year 2018 – 19 was 0.2494 or 25% (approx.)
Usage of Gross Margin
1. Ability to retain
Gross margin percentage, as mentioned previously, defines the relationship between a company’s gross profit and its net sales or total revenue. For instance, as per the above case of Maruti Suzuki, the company was able to retain Rs.0.24 from each rupee of profit generated in FY 2018 – 19.
As a result, for shareholders and investors, gross margin acts as an indicator of a company’s financial health. It provides insight into how efficiently a company is managing its costs of production of goods or rendering of services and how well it can sell the same.
Such inferences are crucial to investors when gauging a company for investment purposes. The more a company can retain from its revenues, the more it can invest in developmental endeavours. Such healthy prospects tend to encourage investors’ confidence that, in turn, results in increasing share prices.
2. Financial footing
Studying gross margin across periods can also facilitate an understanding of a company’s financial footing over time. That is also a determining factor for investors.
Let’s take the example of Maruti Suzuki Private Limited for three fiscal years. Its gross profit and total revenue are mentioned in the table below.
|Particulars||Financial Year 2016 – 17 (Rs.)||Financial Year 2017 – 18 (Rs.)||Financial Year 2018 – 19 (Rs.)|
Gross margin for FY 16 – 17 = (165710000 / 676610000) = 24.49%
Gross margin for FY 17 – 18 = (203322000 / 791818000) = 25.68%
Gross Margin for FY 18 – 19 = (213136000 / 854573000) = 24.94%
Thus, it can be seen that Maruti Suzuki’s gross margin has stayed more or less stable over these three accounting periods.
In case a company notices a drop in its gross margin rate, it needs to make arrangements to reduce production costs or labour costs to bring the margin back to normalcy. It can also increase the prices of its products for that purpose.
Gross margin is also used to compare companies with different market capitalisations.
For instance, suppose there are two companies – Company MNC and Company NGO. The former recorded total revenue of Rs.2 crore and gross profit worth Rs.1 crore in FY 19 – 20. The latter’s books showed total revenue of Rs.50 lakh and gross profit of Rs.35 lakh in the same period.
Therefore, Company MNC’s gross margin would come about to be 50% (10000000 / 20000000) and Company NGO’s gross margin would be 70% (3500000 / 5000000). Even though Company MNC recorded huge revenues, its gross margin fell short when compared to that of Company NGO’s.
Such comparisons facilitate better judgement concerning a company’s cost management as well.
Gross Margin vs Net Margin
The scope of expenses in case of gross margin equation is narrower compared to that of net margin. When the net margin is calculated, all expenses, both directly and indirectly related to revenue generation are deducted from total revenue.
Therefore, gross margin provides an understanding of a company’s operational profitability. Net margin, on the other hand, sheds light on a company’s overall profitability.
- What does a company’s gross margin denote?
Companies utilise gross margin to measure their revenue in relation to their production costs incurred. When a company’s gross margin is low is attempts to curb its spending on raw materials, labour, etc.
- What can be considered a good gross profit margin?
The gross profit margin for companies varies from one industry to another. However, if the profit margin is considered according to the rule of thumb, a 10% margin is average while the 20% margin can be high/good.
- How can the gross margin percentage be calculated?
Gross margin percentage is given by = (total revenue generated – the total cost of the goods sold)/ (100X total revenue earned)