Gross Margin Ratio

Gross margin ratio is the ratio of gross profit of a business to its revenue. It is a profitability ratio measuring what proportion of revenue is converted into gross profit (i.e. revenue less cost of goods sold).

Formula

Gross margin is calculated as follows:

Gross Margin = Gross Profit
Revenue

Gross profit and revenue figures are obtained from the income statement of a business. Alternatively, gross profit can be calculated by subtracting cost of goods sold from revenue. Thus gross margin formula may be restated as:

Gross Margin = Revenue − Cost of Goods Sold
Revenue

Analysis

Gross margin ratio measures profitability. Higher values indicate that more cents are earned per dollar of revenue which is favorable because more profit will be available to cover non-production costs. But gross margin ratio analysis may mean different things for different kinds of businesses. For example, in case of a large manufacturer, gross margin measures the efficiency of production process. For small retailers it gives an impression of pricing strategy of the business. In this case higher gross margin ratio means that the retailer charges higher markup on goods sold.

Examples

Example 1: For the month ended March 31, 2011, Company X earned revenue of $744,200 by selling goods costing $503,890. Calculate the gross margin ratio of the company.

Solution
Gross margin ratio = ( $744,200 − $503,890 ) / $744,200 ≈ 0.32 or 32%

Example 2:
Calculate gross margin ratio of a company whose cost of goods sold and gross profit for the period are $8,754,000 and $2,423,000 respectively.

Solution
Since the revenue figure is not provided, we need to calculate it first:
Revenue = Gross Profit + Cost of Goods Sold
Revenue = $8,754,000 + $2,423,000
Revenue = $11,177,000
Gross Margin Ratio = $2,423,000 / $11,177,000 ≈ 0.22 or 22%

Written by Irfanullah Jan