Gross Margin Ratio

The Gross Margin Ratio, also known as the gross profit margin ratio, is a profit ratio that compares a company’s gross margin to its revenue. It demonstrates how much profit a company makes after deducting its Cost of Goods Sold (COGS).

The ratio represents the percentage of revenue retained as gross profit by the company.

For example, if the ratio is 20%, it means that for every dollar of revenue generated, $0.20 is retained while $0.80 is attributed to the cost of goods sold. The remainder can be used to cover general and administrative expenses, interest expenses, debts, rent, overhead, and so on.

The gross profit margin is calculated by subtracting direct expenses or cost of goods sold (COGS) from net sales (gross revenues minus returns, allowances and discounts). That number is divided by net revenues, then multiplied by 100% to calculate the gross profit margin ratio.

Gross Margin Ratio = (Revenue – COGS) / Revenue

The ratio determines how profitable a company’s inventory can be sold. A higher ratio is preferred. There are two common methods for increasing the figure:

1. Purchase inventory at a lower cost.

Companies’ ratios will increase if they can obtain a large purchase discount when purchasing inventory or find a less expensive supplier. This is because the cost of goods sold will be lower.

2. Increase the price of goods

A higher ratio would result from marking up goods (selling goods at a higher price). However, this must be done in a competitive manner; otherwise, the goods will be too expensive, and fewer customers will buy from the company.

On the surface, a gross profit margin ratio of 50 to 70% would appear to be healthy, and it would be for many types of businesses, including retailers, restaurants, manufacturers, and other goods producers.

However, for other businesses, such as financial institutions, law firms, or other service industry firms, a gross profit margin of 50% may be considered low.

Gross profit margins in the high-90 percent range are typical for law firms, banks, technology companies, and other service industry companies. This is due to the fact that service sector firms typically have much lower production costs than goods-producing firms.

Unlike in the service sector, the gross profit margin ratio in clothing retailing can range from three to thirteen percent, with some fast-food chains achieving gross margins as high as forty percent.

“Gross margin is critical to getting right,” says Beniston, CPA and MBA. “But it’s all relative.” If I’m a heavy equipment manufacturer, it wouldn’t be useful to compare my gross margin to that of a retail operation for benchmarking purposes.”

While the gross profit margin ratio can assist business owners and professional advisers in determining a company’s financial health, it is best used to track a company’s performance over time or to compare businesses in the same industry.

The gross profit margin ratio will not only tell you whether your company is meeting the industry standard, but it can also be used as a target to exceed the industry standard.

Business owners can use the gross profit margin ratio to “benchmark against the industry,” according to Beniston. Then set some goals and keep track of them over time. So, if the industry standard is 65 percent, let’s make sure we’re comparable and, if so, aim for 70 percent. The key then is to track on a monthly basis, to see how you are doing in comparison to the industry and the goals you set.”

In theory, as your revenue grows, your cost of goods sold should rise proportionally, according to Beniston. “If your cost of goods sold increases faster than your revenue growth, you have a problem.” When those trend lines intersect, your ability to stay profitable is jeopardised.”

It’s possible that your cost of goods sold has risen, but your pricing hasn’t changed to reflect the increase in costs. Alternatively, your business operations are less efficient than your competitors’, causing your COGS to rise faster than your revenues.

“If you’re falling behind in your industry, make sure that it’s not due to uncontrollable events and that you become introspective and ask, ‘How can we do better?'” “The gross profit margin ratio focuses on your pricing strategy and operational efficiency,” says Beniston.

The cost of labour, materials, and other variable costs of production all have an impact on operating efficiency.

Of course, the gross profit margin ratio has limitations in terms of what it can tell you about your company’s efficiency, profitability, and long-term viability.

Other profitability measures, such as operating profit margin and net profit margin, will tell you more about how efficient and profitable your business is after depreciation and amortisation, as well as interest costs and taxes.