How to Use Gross Margin Analysis

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.

• The total amount of earnings that flow into your business.

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.
• Revisit your accounting system:
  • Create separate lines for the fluctuating COGS categories that are fluctuating the most and have the biggest impact.
  • Create separate lines for labour and materials – they can move in different directions.
  • Create separate lines for any variable cost that impacts your business.
• This will make it easier to track and study this data in future.

Suggestion:
Develop “Modules” within a “DashBoard” that let you keep an eye on your business.
You are already familiar with the role of a car dashboard and this acts in the same way.

Further reading on this topic at the article: Interpreting The 12Faces DashBoard