Gross Margin Ratio Analysis is:

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

In the previous Topic, we discussed differences in each of the costs categories, not the overall relationship. The Gross Margin Ratio does this.

The Gross Margin Ratio:

  • Automatically adjusts for changes in Revenue and Operating Costs which might move in different directions and be hard to interpret by themselves..
  • If it goes up, you are doing better financially.
  • Alternatively, if it goes down, you are doing worse.

To calculate:

  • Divide Gross Profit by Revenue = Gross Margin percentage for each period.
  • Gross Profit = Income – Operating Costs

The figures come from your accounting system Profit & Loss report.

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%. This is a bad trend and deserves inspection for why it has happened.

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, and their meaning, may be:

  1. Income increased and Gross Margin increased:
    Your income has gone up and your Operating Costs have actually fallen in proportion.
    This is a good thing and means your problem is likely in Fixed Costs.
  2. Income increased and Gross Margin fell:
    Although you earned more Income, your Operating Costs 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 and/or reduce your costs if possible.
  3. Income fell and Gross Margin rose:
    Even though your sales fell, your Operating Costs fell as well and you are actually better off.
    Any problem with falling Operating Profit likely lies in your Fixed Costs.
  4. 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 what is produced. This is an inventory problem.

In our experience, the Gross Margin Ratio is one of the most valuable measurements you can do. It is generally the first thing we check.

The reason it is so common is due to inflation on your Operating Costs. Each year, your labour (both casual and permanent), is probably getting a wage hike. Also, there will be inflation CPI adjustments to inventory and energy.

If you fail to increase your prices to compensate, your Gross Margin Ratio and your Gross and Operating Profits will fall. The Gross Margin Ratio tracks this and is your early warning system for profit falls due to inflationary pressures.

Now, calculate your Gross Margin percentage and follow the guidelines above for solutions.

For more help understanding any issues relating to this Section of the Turnaround90 Campaign, use the 12Faces Diagnostic System to drill down to root causes of problems and find our suggested Treatments.

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