A company's profitability is the result of many different business policies and decisions. There are several different profitability ratios which help a manager assess how effectively a company is being run. These profitability ratios—return on equity, return on assets, gross margin, and profit margin—should be reviewed over time, to see whether the company's profitability is increasing or decreasing. They should also be looked at in conjunction with an examination of the complete income statement, to identify the particular aspects of the business—sales, overhead, profit by division or product line, and the like—that are contributing to the company's overall profitability.
One of the most widely used measures of profitability is the gross margin. It is the ratio of operating profit to net sales.
Gross margin measures the difference between your selling price and the cost of the goods you sold. In the case of manufacturing, the cost of goods is the production cost, excluding selling and overhead expenses. In distribution industries, the cost of goods sold generally represents the price you paid for the goods you are reselling. Some people like to think of your gross margin as what is available to run the company after selling your product.
Who's Watching:
Like the profit margin, the gross margin is primarily of interest to a company's managers and owners as a measure of the funds generated by each sale. Bankers, other lenders, and investors are also interested in the gross margin as one indicator of a company's general profitability.
Business Factors:
The gross margin is a result of (1) how much markup you can add to your products, and (2) how much you can lower the cost of buying or producing the products.
Prices, in turn, depend on the specific industry you are in and on the business cycle. For example, new technology industries and industries with few competitors can often charge a higher price relative to their costs of goods. In industries selling a standard product, using older technology, or those with many competitors, price competition is often intense and gross margins may therefore be lower. Also, during times of industry recession, price competition is often more pronounced than during business expansions.
The production cost side of gross margin -- that is, the cost of goods sold -- is affected by the efficiency of your production process and materials costs.
Accounting Factors:
Gross margin is also affected by the inventory valuation method you use. For example, in a period of rising prices, the first-in-first-out method of inventory valuation will result in relatively low costs of goods sold, because the oldest, lowest priced goods are considered to be sold first. The last-in-first-out method, conversely, treats the most recently produced item as the one being sold first, and therefore will tend to yield higher costs of goods sold.
