Understanding Gross Margin in a financial statement

Gaurav Chhabra

We all know the basic formula (mentioned below) of gross margin but there is a lot that we can derive out of it in terms of its application and how we use and interpret it when someone throws the same metric to us for a particular company.

Fundamentally, there are companies which have lower gross margins than others. It depends on the value addition done by the company.

A product’s journey can be broken into two stages:

  1. From raw material to finished good production: All costs are taken as COGS and after subtracting these costs from revenues we get Gross Profit
  2. From finished goods to placing it in the hands of end consumers: This includes lot of expenses. Eg being: outward logistics, channel commissions, sales and marketing commissions, administrative overheads, research and development and advertising expenses etc. All these functions though do not play a direct role in making a product but these are critical to take products to the right consumer at the right price.

Companies having high gross profit margin tend to earn higher net profit margins as well. This happens primarily because these companies have lots of elbow room to create wide and deep moats around their business and letting them charge higher from the customer as well as create value for their clients.


Examples

A low gross profit product such as petrol sold by company HPCL has gross margin ration of little less than 3%. Now company only has 3% of the costs left to do marketing, advertising, research and development and pay its employees in the central locations. Such companies are still able to survive because of very high revenue numbers, which means though in percentage terms the number is very low but in absolute terms it is very high.

A high margin business such as information services, a player being TCS will have a gross margin north of 70%. This gives TCS a lot of muscle to do spend a lot on research and development, spend massively on sales efforts to take its services to clients on per dollar basis in comparison to HPCL.


Accounting details of gross profit calculation

Gross Margin = (Revenue — Cost of goods sold (COGS))/ Revenue

  1. Revenue we all know is the invoice value (price times quantity sold) at which company sells its goods, it can be different depending on what channel it uses to sell the goods. For eg. a package shipped directly to customer from a manufacturing location will have a different price then the same package sold via dealer or distributor channel (To ensure there is enough margin to be made by channel partners)
  2. COGS: All costs that go directly to ensure that product that needs to be sold is ready. This include various elements:

2 (a) Material cost: This includes raw material, semi finished products or finished products procured from outside that goes into production. Eg to manufacture a tubeless tire, a company procures raw tire, it procures steel. This all goes into COGS. This also includes inwards logistics cost if borne by the company

2 (b) Direct labour cost: Labour working on shop floor and inside the factory is part of this. This will include from sweeper in the washroom to the plant manager

2 (c ) Overheads: This include rent, electricity, telephone charges of factory or any other charge

2 (d) Depreciation and repair and maintenance: All maintenance costs whether incurred internally or given to a vendor becomes part of this

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