# 4.2. Margins

#### Gross margin

Gross margin is a ratio that demonstrates the profitability of a business from its net sales (gross sales minus discounts and returns). Using the accounts of the Income Statement by natures, the gross margin of sales is given by:

• $$Gross\ margin\ of\ sales=\ \frac{Net\ sales-Raw\ materials\ and\ consumables}{Net\ sales}$$

In the strict sense of gross margin of sales, it refers to the sales of products and not to services. It is an indicator that is commonly used and that allows an accurate perspective on the gross return of products and goods marketed. Through the gross margin of sales we measure the profitability of the company when it sells its inventory.

The higher the ratio, the more favorable it will be the for the company, because a higher ratio means that the company is selling its products at a better margin over cost. To improve the gross margin of sales there are two factors:

• The company increases the price and inherently the value perceived by customers. Still, one should pay attention and check if margin growth is obtained through a cannibalization of turnover; if that occurs the profitability of the company may suffer as it is dependent on other factors like the proportion of fixed and variable costs.
• Through a stronger policy of negotiation with suppliers to achieve a reduction of the COGS.
##### Difference between gross margin and margin over cost

It is important to note that, by definition, gross margin of sales refers to the profit from the sale of the good on the turnover. Knowing that, companies often set their prices based on the addition of a margin to the cost of acquisition or production, you should be aware that the gross margin does not correspond to this concept of value added to the cost of acquisition or production, as demonstrated in the following example.

###### Example – Two situations involving days of VAT balance

The company XAB is the sole importer and distributor of GreatTyres, a prestigious brand of tires. The company sells all over the country and the respective commercial policy is defined by adding a percentage of 35% to the cost of acquisition, a policy that is applied to the products sold. In 2014, a cost of goods sold and materials consumed of 6,375,000 EUR and inherently, a turnover of EUR 8,572,500 (corresponds to the application of the factor of 1.35). The gross margin of sales of XAB is:

• $$Gross\ margin\ of\ sales=\ \frac{8.572.500-6.375.000}{8.572.500}\times=25,9%$$
##### Gross margin of services

If the business of the company involves both sales and services, the analyst may choose one of the following:

• To isolate what strictly respects to the sales of products and use the gross margin of sales;
• To consider that the services and the sales are inseparable and complementary and the output of both inventory refers to the sale of products as well as to the services provided. Then the gross margin should be:
• $$Gross\ margin=\ \frac{Revenue-Cost\ of\ goods}{Revenue}$$

The gross margin of services is a separate concept, typically used by companies whose business is service related. It assumes the existence of costs that are related to the services, such as employees’ benefits.

• $$Gross\ margin=\ \frac{Services-Employees’\ benefits}{Services}$$

In some service industries there are also consumables that are needed for a company to provide a service. If that is the case, then it should be taken into account as well.

• $$Gross\ margin=\ \frac{Services-Employees’\ benefits-COGS}{Services}$$
##### Gross margin through the Income Statement by functions

Since in the Income Statement by functions we already have COGS that compound all directly attributable costs to the production, the calculation of the gross margin is immediate and more accurate than using the elements of the Income Statement by natures, independently of the industry of the company.

#### Net margin

At first there may be a tendency to confuse the concepts of gross margin and profit margin, but these are distinct. Gross margin, as seen, just consider the cost of production, purchase of the goods or services. The net margin includes other expenses and is given by the ratio between the Net income and revenue.

• $$Net\ margin=\ \frac{Net\ Income}{Revenue}$$

The net margin measures the proportion of net income that is generated for each monetary unit of revenue. This ratio is commonly used to measure the efficiency with which the company converts the net revenue into results.