Gross Margin

If we want to find gross income, we have to minus cost of sales from net revenues. This will show how efficient the company is able to manufacture one unit of product depending on its value in the market. This difference includes only variable cost of the product and shows how big the markup is put on the products cost price. This gross margin is distributed to other segments of the business - administration and other costs that are fixed and other purposes - like research and development, new inventory or equipment.

If the company is commercial, the gross margin is depending on the type of sector, but it mostly depends on the type of product. Usually the gross margin for such companies is lower than for manufacturing companies, because it is thought that it is cheaper to produce the product rather than to buy it from someone else and resell it. Here will be two examples to explain this.

To imagine the picture of gross ratio, we can say, that the company is selling the tool box for 50 Euros. The cost to manufacture it, is 20 Euros. So the company is using 30 Euro markup, which is also gross profit for the company. 30 Euros from 50 Euros is 40%, which is the cost of the tool box. The company applies 150% markup on a product's cost price when selling it and makes 60% gross profit, which is also called gross margin. This calculation means, that one Euro of sales gives 0,6 Euro of profit, which can be allocated for other sectors in the business after covering variable costs.

Let's take a more difficult example of a different type - a commercial company. The other manufacturer, which is making tool boxes, can manufacture one for the same 20 Euros, and he sells it for 30 Euros for Distribution Company. Then, the distribution company sells one tool box for 60 Euros. The markup for manufacturing company is 10 Euro per tool box, or 50%, while markup for distributor is 30 Euros, or 100%. To look at the gross margin ratios, we can say, that for the first company it is 33,33% while for the commercial company - 50%.

As you can see, the manufacturing company in the first example, which sells its production by itself, is more profitable, more efficient and more competitive. Even if both companies are making the same products at the same costs, the first company is able to make higher profit per tool box by applying higher markup and selling the product cheaper than the second company, whose markup and profitability is lower. This example explains why it's better to buy product form the firsthand.

The investor of course will choose the company, which is more perspective and has higher gross margin ratio, because it has more possibilities to achieve better results by investing in the growth of the company, researches and quality of the product. Higher gross margin brings higher profit per product and show company's ability to use its resources effectively and at the same time earning higher markup.

Article Source: Donatas S