The gross margin ratio is a financial metric that indicates the percentage of revenue remaining after deducting the direct costs of producing goods or services, expressed as a percentage of Net Sales.
Primary Implication
The higher your Gross Margin Ratio, the better. The more gross margin you generate, the more money flowing into the business to make a profit after paying direct costs. A low gross margin indicates a business likely operating at a loss with insufficient money to pay other business expenses.
The month-to-month change in the Gross Margin Ratio is the most important number to pay attention to in every business.
If your gross margin ratio is improving, then you are either capturing a higher price or you have lowered your direct operating costs.
If the ratio is declining, it is an early warning that you have growing problems that need your attention.
Overview
The Gross Margin Ratio is a Profitability Ratio that represents the percentage of pure profit from the sale of the cost of goods sold. The higher the percentage, the more money that exists to pay the balance of fixed and nonoperating expenses of the business.
A falling gross profit shows that production costs are rising faster than the selling price, or that inventory is shrinking due to fraudulent activity or product spoilage. A higher Gross Margin Ratio is achieved in two ways:
- Reduce costs by buying materials or labor at a lower price
- Sell your products at a higher markup.
A high Gross Margin Ratio means stability in times of economic downturn because the company can afford to cut prices.
A low gross margin may mean low creditworthiness, or the inability to fight off competition.
The formula for Gross Margin Ratio is as follows:
(Net Sales – COGS) / Net Sales
A 40% gross margin means that for every dollar of sales, 40 cents remains from that sales dollar after the cost of goods sold is paid to cover the non-operating or fixed expenses before a profit is realized.
Higher is Better: resulting in more money for the company to make a profit after paying direct costs.
Lower is Worse: company is likely operating at a loss with less money to pay other business expenses.
