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.

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.

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.