How Gross Margin Analysis Boosts Profit Explained

How Gross Margin Analysis Boosts Profit Explained

Gross Margin Analysis opens the door to understanding the complex interactions between Revenue, COGS (Cost of Goods Sold or Operating Expenses) and Gross Profit.  It can be hard to understand why (e.g.) Revenue is going up but Gross Profit is going down!  Gross Margin also lets you measure the operating efficiency of your business and points out which components of your COGS may be declining in efficiency.  Bottom line, an improving Gross Margin is a good sign for improving profitability in your business.  Yellow Belt

When to Use

The Gross Margin %, or Gross Margin Ratio, is a ratio which allows you to:

  • Diagnose problems caused by changes in the relationship between Revenue and COGS.
  • Revenue and COGS 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’s profitability.
  • Gross Margin % does that, and allows the efficiency of your production processes to be tested.

Data Required

The main data you will be dealing with here is:

  • Revenue (income)
  • Cost of Goods Sold (costs of production, Operating Costs or COGS)
    • 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 Profit (Revenue less COGS)

If those terms are not familiar to you, check alternative phrases in our Accounting Terminology Translator

This data will be available in your accounting reports.

For best results, you want to compare the results for two periods so that you can see what has changed.  Ideally, use full year annual accounts from two adjacent years.

Calculation

The Gross Margin % is one of many ratio analyses that can measure the health trends of your business.
Ratios measure the change in one aspect of your business (a variable) compared to another one.
They show performance trends over time.

Gross Margin % (or Gross Margin Ratio) = Gross Profit / Revenue X 100

Example:

  • Figures last year were: $200 Gross Profit / $1,000 Revenue = 20% Gross Margin %
  • Figures this year: $100 Gross Profit / $1,200 Revenue = 8.3% Gross Margin %
  • The Gross Margin % has fallen from 20% to 8.3%.

Interpreting

From the example above, you can see:

  • Gross Profit has fallen from $200 to $100 (halved).
  • This is despite Revenue going up from $1,000 to $1,200.
  • This means that though sales have gone up you are not controlling COGS.
  • Your Gross Margin % has therefore gone down.

Some of the likely changes may be:

Revenue increased and Gross Margin % increased:

  • Your Revenue has gone up and your COGS have actually fallen in proportion.
  • This is a good thing.  Your operation is becoming more efficient. 
  • If Operating Profit has fallen, your problem is likely in Overhead Costs.

Revenue increased and Gross Margin % fell:

  • Although you earned more Revenue, your COGS has 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 consider raising your prices if possible.

Revenue fell and Gross Margin % rose:

  • Even though your Revenue fell, your COGS fell as well by even more proportionally so you are actually more efficient
  • even though more efficient, your Operating Profit may fall because of the impact of falling Revenue

Revenue fell and Gross Margin % fell:

  • Your Revenue fell and COGS got higher, your COGS like labour and raw materials may have gone up.

What Is a “Good” Gross Margin %

There is no single “good” figure for  “Gross Margin %”.  It will vary widely, depending on the nature of your business.

Examples:

  • A grocery shop’s retail selling prices are not much greater than the cost of the products they sell.
  • In an industry where you have few competitors you are able to charge more for your products.  We would expect the “Gross Margin %” to be much higher.
  • The “Gross Margin %” would be higher where most of the cost is permanent staff. Staff is an Overhead Cost.  Examples are a consultancy or accounting practice.

There is quite a lot of information to be gained from the study of “Gross Margin %” when you look at it over time.

Your Revenue will change and independently of that, your COGS will change.
Because both of these change, your Gross Profit will also change; but you may not be able to tell why.
Remember: Gross Profit = Revenue – COGS.

As they change, the Gross Margin % will, consequently, go up and down.
Remember: Gross Margin Percentage = Gross Profit / Revenue x 100.

The fluctuation in your Revenue and COGS is very confusing when you are trying to see if you are better or worse off over time.
The Gross Margin % is a useful tool for trying to see the aggregate impact of changes in your Revenue and COGS.  These are otherwise quite difficult to work out.

Goals

1: Your goal is to keep your Gross Margin % at least steady.
This means your Revenue and COGS are moving in the same direction at similar rates so your Operating efficiency is stable.

Even better, if the Gross Margin % is growing, it reflects increasing efficiency and economies in your business.

If Gross Margin % falls, your Revenue and COGS are moving apart and need correction.  Your operations are becoming less efficient.

2: You can research “normal” Gross Margin % for your industry and use them as a benchmark for your own business.

If you are below benchmark, it might mean you are below the average operating efficiency.

So, although your Gross Margin % is steady, maybe you should be setting your sights higher.  That should lead to better Gross Profit and probably Operating Profit.

or

You can Google Gross Margin benchmarks.

Future Proofing

If this analysis turns up anything of interest:

  • Continue monitoring the figures in the future.  The 12Faces TrendBoard is designed to make monitoring easy
  • Spot good changes and take advantage of them.
  • Spot bad changes and take prompt action to limit their effect.
  • Revisit your accounting system:
    • Create separate accounting lines for COGS like casual labour, raw materials and direct marketing and other COGS types
    • They can fluctuate in different directions (up and down) and in different proportions and therefore have different impacts
    • This will make it easier to track and study this data in future

Deeper Analysis

Your COGS is made up of several contributing costs like:

  • Casual labour
  • Raw materials
  • Energy and other consumables

There are separate 12Faces analyses you can use to measure the contribution impact of each of these different types of COGS.  

You can subscribe to our more powerful analysis tools like TrendBoard to have these calculated for you.

Or you can calculate them for yourself using the information in the article: Critical Business Financials Explained

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