Why is Gross Margin Analysis Critical for Business!!!
Why is Gross Margin Analysis Critical for Business!!!
Let us begin with what is Gross margin,
As the formula goes,
Gross Margin = Net Sales – COGS, where COGS is Cost of Goods Sold
Gross margin is a company’s net sales revenue minus its cost of goods sold (COGS). In other words, it is the sales revenue a company retains after incurring the direct costs associated with producing the goods it sells, and the services it provides. The higher the gross margin, the more capital a company retains on each dollar of sales, which it can then use to pay other costs or satisfy debt obligations. The net sales figure is simply the gross revenue, less returns, allowances, and discounts.
Profitability is one of the key aspects that business managers, investors and other stakeholders look into in order to assess whether a business is successful or not. Hence, the business must maintain a good gross profit margin. A company that is profitable will be able to pay its liabilities as they fall due. Profitable companies are also capable of distributing dividends to investors.
There are many ways to assess a company’s profitability or business margin or net profit margin; and there are many tools that are available to conduct profitability tests. One of them – and quite probably the most popular one – is by looking at the company’s profit margin, margin analysis report, or the percentage of profit out of total sales or receipts of the company for a given period or operating cycle.
How does Gross margin help?
The gross margin represents the portion of each rupee/dollar of revenue that the company retains as gross profit. As we know, profit margin is one of the most commonly used and most dependable indicators of profitability of a company. Investors are generally keen on seeing how the management of a company is able to generate returns, manage its costs and expenses, and generate revenues over time. It is basically a reflection on how efficiently resources are utilized in business operations.
Companies use gross margin analysis for their business to measure how their production costs relate to their revenues. For example, if a company’s gross margin is falling, they may use alternative/cheaper materials, change suppliers for products. Alternatively, it may help as a revenue increasing measure, to measure company efficiency or to compare two companies of different market capitalizations.
Changes in gross profit can be caused by change in selling price, units of products sold, the product mix, purchase price of inventory, the volume of direct materials, the labor rates and usage of overhead. Thus, it is important to maintain an ideal gross profit ratio.
Profitability analysis is a type of income statement analysis where an analyst assesses how attractive the economics of a business are. Let us understand through an Income statement the impact of key drivers on the change in gross margin over time.
Sales refers to the gross earnings or receipts from the sale of products and services of a business.
Sales discounts are usually concessions received in the price for an early payment made by the buyer or purchaser. Sales returns are the products that are send back due to various reasons such as defect, wrong order, delay in delivery, etc. Sales allowances are reductions in the price of a product or service, mainly due to problems with the quality of product or service.
Net Sales refers to the total revenue after discounts, returns and allowances are deducted from sales.
Cost of sales or cost of goods sold indications to the cost which are directly attributed to the products sold.
Gross Profit is the profit generated from the sales.
Operating cost and expenses include all expenses made by the business right from general to selling and administration expenses.
Operating profit is the profit earned before deduction of interest and taxes.
Interest and taxes are the finance cost which is mandate to be paid to the government irrespective of outcome of operations.
Net Profit is the net margin of the company.
Since Gross profit margin does not include things like interest payments, taxes, or operating expenses it is essential to identify key profit indicators to assist with decisions making so that there is surplus profit left at the end of the day. There are various factors which influence increasing and decreasing margin like wrong pricing, cost of materials, payment to labor, etc. Also, external factors such as inflation and deflation affect the EBITDA margin.
How can we help:
Typically, to generate a report for one product and vendor group, an accountant would spend weeks drawing data and tracing excel formulas to produce a single analysis. Some organizations have a range of product categories and a list of vendors. And making reports on all categories impossible. The management can monitor the key sales metrics of revenue, gross profit margins by using sales data and can provide standalone and consolidated data of each product, vendor, customer, category, region wise. These charts and reports can also track growth and helps identify both positive and negative factors.
Gross margin helps determine the customer profitability, profitability analysis, revenue by customer etc. on a month on month, year on year basis by analyzing the past and current data and can also forecast the future profitability.
Waterfall chart showing the change in Gross Margin between 2 quarters
This gives a better understanding on the drivers of margin at a category level across all product categories. We take two known periods and measures the impact to margin for different drivers (levers) of revenue and cost between them. This is customized based on the levers of margin for each specific customer.
We effortlessly analyze your need to be augmented by our understanding of the business and discussion with management to develop your business better.
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