# 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.

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:

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

#### Example case: Dutch Fabric Innovations

DFI calculates its gross margin with the following elements from the income statement:

 Values in EUR 2020 2021 2022 2023 2024 Net Sales 0,00 2 480 875,00 5 404 150,00 10 128 250,00 15 940 000,00 Raw materials and consumables 0,00 1 456 300,00 3 144 790,00 6 018 700,00 9 431 900,00 Gross margin 0,00% 41,29% 41,80% 40,57% 40,82%

DFI starts producing and selling in 2021 and in that year, it presents net sales equal to 2 480 875€ and costs with raw materials and consumables of 1 456 300€. This originates a Gross Margin of Sales of

• $$Gross\ margin=\frac{2\ 480\ 875,00-1\ 456\ 300,00}{2\ 480\ 875,00}=\ 41.29%$$%

This means that the company will retain as gross profit 0.4129€ of each euro of revenue generated. The gross margin is the amount of revenue that is kept after paying expenses, in this case, 0.4129€ per year of revenue.

We can observe that after an increase in 2022, the margin decreases in the next two years. This happens because both the prices of the fabrics and the cost of the raw materials decrease, but price decreases more than the cost of raw materials.

### Gross margin in the presence of services

#### Revenues with services and sales of products

For analytical purposes, if a company has revenue coming from sales of products and from services, you may choose one of the following options:

• Isolate what strictly respects to the sales of products and only use the gross margin of sales;
• Consider that services and sales are inseparable and complementary and that raw materials costs and consumables are attributable to revenue as whole. Then the gross margin should be:
• $$Gross\ margin=\ \frac{Net\ Revenue-Cost\ of\ goods}{Net\ Revenue}$$

## Other approaches to the gross margin

You may want to analyze the gross margin from a different angle: the costs with employees are considered to be fundamental to generate revenues and should be considered as productive costs. This may not be true for every employee (administrative or marketing workers usually do not take part in the production). Under such perspective, the gross margin can be computed as:

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

If there are also raw materials and consumables costs, then these should be taken into account:

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

#### 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.

#### Example case: Golden Days

Golden Days, provides services, incurs in expenses with raw materials and consumables and its employees are not attributed to functions. Hence, the best solution is to calculate the gross margin without employees costs.

 Values in USD 2019 2020 2021 2022 2023 Net Sales – 719 250,00 1 433 500,00 1 764 800,00 1 975 500,00 Raw materials and consumables – – 49 275,00 60 915,00 68 310,00 Gross margin 0,00% 100,00% 96,56% 96,54% 96,54%

Golden Days only starts selling its services in 2020. As a result, it has no revenue in 2019 and, when computing the Gross Margin of Sales, the result is zero.

As for 2020, the company starts getting revenue from services, but in this year, it doesn’t have raw material and consumable costs. This happens because only the catering services require raw materials costs and this line of service is only offered from 2021 onwards. Therefore, as costs with raw materials is zero, the gross margin is 100%.

In the following years, there are raw materials costs from the catering service. Since these costs are a fixed percentage of the revenue from catering, the gross margin stays relatively constant over time. This constant margin tells us that the company will retain as gross profit approximately 0.966$of each dollar of revenue generated. • $$Gross\ Margin=\frac{1433500-\ 49275}{49275}=96.56$$% ## 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. #### Example case: Dutch Fabric Innovations The following elements are needed from DFI’s income statement:  Values in EUR 2020 2021 2022 2023 2024 Net Income -72 721,34 87 124,55 559 685,36 1 507 446,43 2 918 994,03 Revenue 0,00 2 480 875,00 5 404 150,00 10 128 250,00 15 940 000,00 Net Margin 0,00% 3,51% 10,35% 14,88% 18,31% In 2021, DFI registered a net income of 87 124,55€ and a revenue equal to 2 480 875€. • $$Net\ Margin=\frac{87\ 124,55}{2\ 480\ 875,00}=3.51$$% This means that 3,51% of each unit of revenue will be converted into net income. This ratio increases up to 18,31% in 2024. Knowing that the higher the ratio, the more efficient a company is, DFI becomes more able to increase the efficiency with which it generates profit from sales. #### Example case: Golden Days The following elements are needed from the income statement:  Values in USD 2019 2020 2021 2022 2023 Net Income -36 968,23 21 382,86 166 536,23 217 321,38 249 310,28 Revenue – 719 250,00 1 433 500,00 1 764 800,00 1 975 500,00 Net Margin 0,00% 2,97% 11,61% 12,31% 12,62% Once again, we need the revenues of Golden Days, which are zero in 2019. Consequently, the Net Margin is zero too in this year. In 2021, Golden Days presents revenues of 1 433 500,00$ and net income equal to 166 536,23$, originating a net margin of 11,61%. • $$Net\ margin=\frac{166\ 536,23}{1\ 433\ 500,00}=11,61$$% This margin tells us that, per dollar of revenue, 0,1161$ is converted into net income.

Until 2022, the company sees its net margin increase, leading to an increase in the efficiency with which it transforms revenue into net income.