FOOL SCHOOL
Gross Margin

June 23, 2003

There are many ratios you can look at when you are evaluating a company. One set of ratios relating to profitability is margin.

But, what margin are we talking about? Is it gross margin, operating (or trading) margin, or net margin? Arguably, the only margin we should be interested in is the net margin, which is calculated on the net profit. But each calculation is worth looking at in isolation, as each one can give an indication of how a business is progressing and can be valued.

Margins can give investors an idea of a company's competitive advantage. High margins are usually an indication that a company has a competitive advantage. But the prospect of high profits can invite competition as other companies are attracted to the industry. On the other hand, a company with low margins is not necessarily a poor company. They can be very profitable by selling large volumes of low margin products, just like a supermarket does. Looking at margins is just one tool in an investor's armoury when analysing companies.

Gross margin

Gross margin measures profitability based on the direct costs of getting a product ready for sale. It is the first margin that you will come across as you descend down a company's profit and loss statement. It is calculated as:

                     Gross Profit 
Gross Margin =      --------------                        
                       Turnover   

Where turnover equals sales in any given period, and gross profit equals sales less cost of goods sold. Typically, a company's profit and loss account will start something like:

                 'Year 2'      'Year 1' 

Sales             100,000       90,000 
Cost of Sales     (60,000)     (55,000)
              -----------    --------- 
Gross Profit       40,000       35,000 

We say typically, but many companies don't produce information to this level of detail in their results. Some companies will only report an operating profit figure in their annual reports, making it difficult to see whether the gross profit margin has expanded or contracted between the interim and year end periods. The gross margin in the above example for 'Year 1' was 38.9% (35,000 / 90,000) and 40% in 'Year 2'.

Cost of sales can be defined as the actual cost of producing the product for sale. It will include things like the cost of materials used, wages of staff employed in producing the product, depreciation of machinery used to make the product, and the cost of running the factory where the product is being made.

In a simple example, take a coffee mug manufacturer, Mugs Away (LSE: MUG). It has a small factory in Maidenhead where one worker, Mavis, is employed solely to make nothing else but coffee mugs. Mugs Away hasn't quite hauled itself into the 21st century yet, and Mavis still hand makes her mugs using clay and a kiln. Mavis makes 365 mugs a year and doesn't take any holiday. She's a mugaholic. As each mug is made, it is sold. The total cost of producing those 365 mugs would be something like:

                                    £
Clay including delivery cost    5,000 
Colouring materials             2,000 
Mavis' annual salary           15,000 
Depreciation of kiln            1,000 
Annual factory rent             2,000 
Light, heat & power               550
                               ------ 
Total                          25,550 

The cost of producing and selling the 365 mugs in the year, or Mugs Away's annual cost of sales, is £25,550. The one thing that this tells you is that for Mugs Away to cover the cost of merely producing its mugs, each one would have to be sold for £70 (£25,550 / 365). If the mugs could be sold for £150 each (they're very posh mugs by the way), then total sales would be £54,750. This means Mugs Away would make a gross profit of £29,200 and gross margin of 53.3% (£29,200/£54,750).

This is a very simple example and doesn't take into account the fact that almost all businesses produce goods and products in advance of sales, hence building up stock levels. So, if Mugs Away only sold 250 mugs at £150 in the year its sales would be £37,500. This time its cost of sales would be £17,500 (250 mugs at £70 each) and gross profits would be £20,000. Note that the gross margin is still 53.3% (£20,000/£37,500). The company would carry forward a stock figure of £8,050 (115 mugs at £70 each) to next year's accounts. Assuming the mugs were sold next year, this stock figure would be deducted from next year's profits instead.

There can however be a complication with stocks carried forward. Say the luxury hand made mug market suffers a vicious downturn, and Mugs Away has to slash its prices to £50 to clear its stocks. Accounting standards (yes, accountants do have standards, believe it or not) states that stock should be valued at the lower of cost and net realisable value (NRV). NRV is the actual or estimated selling price.

If Mugs Away were aware of the reduced selling price when it prepared its year end accounts, it would have to write off £20 x 115 mugs = £2,300, hence reducing its stocks and profits in the year in which the mugs were produced but not sold.

Mugs Away may be able to reduce its costs to help its gross margins. Perhaps it could get a cheaper price for its clay and pay only £4,000 a year. Or maybe it could switch its electricity supplier to save £150 per annum in light, heat and power. However, there are other costs to bear in mind as well. These are taken into account when we look at operating and net margins in the next two articles in this mini-series on margins.

> Operating Margin | Net Margin