Gross Margin Analysis:

• Lets you diagnose problems caused by changes in Income and/or Variable Costs.
• Income and Variable Costs can move in different directions, or in the same direction, at different speeds.
• This can make it hard to work out what is causing an upturn or downturn in your business.

The analysis tips here will help make that clearer.  Yellow Belt

## Definitions

The three main terms you will be dealing with here are:

Income:
Also called Revenue.

Cost of Goods Sold (COGS):
Also called Variable Costs and Cost of Sales.

• Refers to any expense that is only incurred when you produce an item.
• The raw materials that go into the product and consumables like energy.
• Casual or outsourced labour.
• Permanent labour is a fixed cost. It doesn’t increase or decrease according to production.

Gross Margin:
Also called Gross Profit.

• Refers to the result of:

Income – COGS = Gross Profit

## Analysis 1: Cost Category Changes

Do you have historical accounting data from previous accounting periods?

Look for changes in each of the Variable Cost categories between accounting periods.

Typical categories are:

• Non-permanent labour
• Energy and other utilities
• Raw materials, packaging, shipping and transport.

Example:
Calculate a ratio of a cost category e.g. labour to revenue.

Year 1:
Revenue = \$1,000 and
Labour = \$100

The ratio is Cost/Revenue:
\$100/\$1,000= 10%.

Year 2:
The Revenue and Labour figures give you a ratio of 20%.

• The cost of labour as a component of Revenue has gone up.
• You are putting more labour expense into the product.

Consider why labour has gone up:

• A wage increase.
• Less efficient labour, more is required to do the same amount of work.
• A change in work methods or machinery which is using more labour.

When you have multiple possibilities like this, the 12Faces article 5 Why’s Problem Solving Technique can be useful to work out what happened.

The Cost/Revenue ratio approach:

• Automatically compensates for any increase or decrease in Revenue or Costs.
• Will always show the relationship between Revenue and Cost, even when both are fluctuating.

## Analysis 2: Gross Margin Ratio

Gross Margin is:

• A measure of how well a company controls its costs.
• The percentage by which Profits exceed production costs.
• The overall relationship between all Variable Costs and Revenue.

Above, we discussed differences in each of the categories, not the overall relationship.

The Gross Margin Ratio:

• Automatically adjusts for changes in Revenue and COGS.
• If it goes up, you are doing better financially.
• If it goes down, you are doing worse.

To calculate:

• Divide Gross Profit by Revenue = Gross Margin percentage for each period.
• Gross Profit = Income – COGS
• The figures come from your accounting system.

Example:

Figures last year were:
\$200 Gross Profit / \$1,000 Income = 20% Gross Margin.

Figures this year:
\$100 Gross Profit / \$1,200 Income = 8.3% Gross Margin.

The Gross Margin Ratio has fallen from 20% to 8.3%.

We can see this is true:

• Gross Profit has fallen from \$200 to \$100 (halved).
• This is despite Revenue going up – \$1,000 to \$1,200.
• This means that though sales have gone up we are not controlling costs.
• Our Gross Margin has gone down.

Some of the likely changes may be:

Income increased and Gross Margin increased:

• Your income has gone up and your COGS has actually fallen in proportion.
• This is a good thing and means your problem is likely in Fixed Costs.

Income increased and Gross Margin fell:

• Although you earned more Income, your COGS have risen even faster making you worse off.
• This may mean raw materials, labour and similar inputs have increased in cost. Selling prices have not increased to compensate.
• You should put up your prices if possible.

Income fell and Gross Margin rose:

• Even though your sales fell, your COGS fell as well and you are actually better off.
• The problem likely lies in your Fixed Costs.

Income fell and Gross Margin fell:

• Your sales fell and costs got higher so your input costs like labour and raw materials may have gone up.
• You might be buying raw materials to manufacture but not selling.
• This is an inventory problem.

## Future Proofing

If this analysis turns up anything of interest:

• Continue monitoring the figures in the future.
• Spot good changes and take advantage of them. and any
• Spot bad changes and take prompt action to limit their effect.