Gross profit margin belongs to the profitability ratio used to understand margins a firm achieves before operating expenses level i.e. selling, general and administrative level or indirect costs and non-operating incomes and expenses level i.e. financial expenses and financial income and corporate taxes.
What Formula?
Gross Profit = Net revenues - Cost of Sales or Cost of goods sold, where
Gross profit Margin = Gross Profit / Net Sales
What Components?
Net Revenue = Gross Sales - Return
Formula 1
Cost of Goods sold = Opening Balance of Inventory (Raw Materials, Work in Progress and finished goods) + Purchases - Closing Balance of Inventory (Raw Materials, Work in Progress and finished goods), or
Formula 2
Cost of Goods Sold = Raw materials costs + Direct Labor expenses + Other direct costs, or
Formula 3
or
Formula 4
Where can I find them - Financial Statement Linkages?
Sometimes COGS is not directly available from the income statement. If that is the case, we can use notes to accounts to find the components given in inventory notes, or hidden in operating expenses, and use the formula 3 or above. Further, certain companies put COGS as operating expenses. Our real company analysis section uses a company that uses operating expenses and COGS.
Real Company Analysis
We take Team Inc. as an example to analyze Gross Margins. Team Inc. is a US based company in the Testing, Inspection and Certification industry. The annual reports of the same can be accessed from https://investor.teaminc.com/.
It can be observed that Gross margin of Team Inc. has earned an average of 27% margin in last six years.
How to interpret?
Gross margin is an important metric for investors as it indicates how much money does a firm make after paying direct costs. Direct costs are cost that are directly related to production or delivery of services. It tells us that how much margin does the firm makes for every US$ 1 sales after paying off its direct costs.
Comparison
Comparison can be done in the following ways:
Temporal comparison, i.e. time series trend analysis
Comparison with Industry benchmark
Comparison with Industry Average or close peers / competitors
Remember when we compare ratios against any average it shall be calculated with same formula otherwise it will result in erroneous comparison.
1. Trend Analysis
As can be seen from our example that Team Inc. has consistently performing with gross margin near to its 6-year average of 27% except for 2021.
2. Comparison with industry benchmarks: If an industry benchmark is available, then we can compare our ratio to it. Industry benchmark is dependent on type of industry. For example,
3. Comparison with Industry Average or close Peers:
But if we compare it with average (median) gross margin of close peers, we find Team Inc. has not outperformed them. It is important to understand that when we compare ratios with peers the selection of right peers/competitor is very important. Direct competitors which sell similar if not exactly same type of product or service, in terms of functionality and not form, shall only be compared.
What Strategic Implications
Gross margin has several strategic implications. As we know that a firm achieves competitive advantage either through cost efficiency or differentiation, it is important to investigate by comparing gross margin of firm, in question with it peers in the industry.
If we see that the firm in question has achieved high margin compared to its close peers we need to further investigate from where the competitive advantage is emanating from i.e. whether it is due to lower cost or high price the firm is able to charge from its customers due to differentiation.
If we see that advantage is coming from lower costs, we need to also investigate how the firm in question is able to achieve lower costs.
How to forecast?
To forecast Gross Margins, we need to forecast revenues and costs. To forecast costs, we need to first list costs components that are used to produce goods or deliver services.
Then we need to investigate what is driving that particular cost. For example, if the firm uses crude oil as raw material, then we can use crude oil prices to forecast costs. If a particular driver is not evident from investigation, then we can use trend analysis to forecast costs.
To forecast revenue, we need to first see what product or services the firm is selling and average prices that are charged for it.
We can use bottom-up approach to find prices and volume to forecast revenue. Based on customer segmentation, we can use pricing surveys to find average price and what price consumer is willing to pay for the product or service within each customer segment.
We can also use top-down approach to forecast revenues. Top-down approach uses macro level data like GDP or private final consumption expenditure to forecast revenues.
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