Gross Margin: More than Just a Mark Up Tool !

Published by slang March 16th, 2006 in Ratio Analysis

A company’s gross margin is basically sales less the direct costs of the product or services. The direct cost of a product in the case of a manufacturer is raw material purchase cost plus direct production costs, such as labor and consumables, plus freight costs. For a wholesaler: Purchase cost plus freight costs, and for a service provider: Cost of materials and consumables plus the cost of the hours providing the service. Gross margin % is derived from the formula: Gross Margin (Sales less cost of goods sold) / Net sales. It varies between industries.

Besides using the gross margin concept in relation to the marking up of products or services, there are ways of using the gross margin % to show us what has gone wrong compared to your budget or previous year/month/quarter.

Firstly, it is important to know whether our gross margin has been eroded or enhanced. Is the erosion or enhancement in gross margin due to:

Sales volume
Changes in costs or selling prices
Both

More importantly, we need to know why we have to appreciate the changes in sales volume or changes in costs or selling prices or both.

Let’s use the following illustrations:

Scenario One: Gross Margin Variance Due to Sales Volume Impact Only

	Actual($)	Budget($) #	Overall GM Variance ($)	=	Volume Variance	Pricing Variance
Sales	200,000	150,000	50,000
GM %	25%	25%	0%
GM $	50,000	37,500	12,500		12,500	0
					(200,000)x(25%-25%)	(50,000)x25%

Scenario Two: Gross Margin Variance due to Sales Volume & with 5% Increase in GM%

	Actual($)	Budget($) #	Overall GM Variance ($)	=	Volume Variance	Pricing Variance
Sales	200,000	150,000	50,000
GM %	30%	25%	5%
GM $	60,000	37,500	22,500		10,000	12,500
					(200,000)x(30%-25%)	(50,000)x25%

# it can be changed to last month, last quarter or last year; not necessarily budget

Pricing here means whether our selling prices of our products –have they been revised ? ; or are higher purchase cost of the products eroding our margin or is it because of inefficient supply chain management which caused higher transportation costs or has the custom tariff rate been wrongly classified hence attracted higher duties, etc

Assuming in Scenario One, we established that there is no pricing variance as there is no variance in the GM% hence the real culprit is due solely to the lack of sales volume. With this, senior management can divert their attention into marketing strategy, more advertising & promotion trying to increase sales, etc

Another key area where we can use Gross Margin effectively is in the area of informing senior management what is our company’s break even point in salesFor the purpose of a model break-even, let’s assume that the fixed expenses look as follows:

Administrative Salaries: $1,500
Rent: $1,200
Utilities: $300
Marketing: $300
Total: $3,300

These are the expenses that must be covered by our gross margin. Assuming that our gross margin is 30 percent, what sales volume must we have to cover this expense?
The answer in this case is 11,000 because 30 percent of that amount is $3,300 or 3,300/0.3=$11,000.

But what if actual sales achieved is just $8,000.00, what then is the explanation? Well, it could be that the senior management started the operation on a wrong footing by investing too much into Grade A building rental or spending too much on expensive renovation to attract customers or promote the company’s image.

Next we look at Gross margin in relation to product mix. It is extremely important to understand that changes in product mix will affect gross margin.

1.ACTUAL Gross Margin Contribution					2.PLANNED Gross Margin Contribution
Dept	Sales $	Sales%	Gm %	Gm Contribution	Dept	Sales $	Sales%	Gm %	Gm Contribution
Stationery	1,500	25%	12%	3.0%	Stationery	2,300	38%	12%	4.6 %
Chemical	1,500	25%	15%	3.8%	Chemical	2,100	35%	15%	5.3%
Hardware	500	8%	16%	1.3%	Hardware	1,100	18%	16%	2.9%
Motors	2,500	42%	22%	9.2%	Motors	500	8%	22%	1.9%
Total	6,000	100%		17.3%	Total	6,000	100%		14.6%

Using the above illustration by “gross margin blending or variable pricing”, we are simply looking at a company’s overall gross margin, which is a blend of the margins obtained from every product it sells.

Incidentally, this extremely powerful concept has always been deployed in the strategies of grocery stores, where the price of milk, for example, is at a very much cheaper price so as to get customers in the store. With typical shoppers, the store can makes up this loss through its profits on the other items that a customer buys before reaching the check-out point.

Lastly, it assists the senior management in looking into the level of investment in relation to gross margin, i.e. gross margin as a percentage of return on capital.

Assuming that :

Product X has a gross margin of 40% and Product Y a gross margin of 30%.The stock turnover of Product X is 2 times per year and the stock turnover of Product Y is 5 times per year.
Assuming each product achieves a sales level of $50,000 per annum the profitability is:

Product X Product Y
$ $
• Sales 50,000 50,000
• Product Cost 30,000 35,000
• Gross Margin 20,000 15,000
• Gross Margin % 40% 30%
• Stock Turnover 2 x 5 x
• Investment in stock 15,000 7,000
• Gross Margin Return on Capital 133.3% 214.3%

• The simple table above illustrates that despite the fact that Product Y has a lower gross margin; it is in fact more profitable than Product X. This is the basic discount store and supermarket strategy, “Pile it high and sell it cheap”

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