Every business organization present in the society has a purpose, which is almost the same for every organization. The ultimate achievement of the company is decided by the profit that it retains at the end of every financial year. This year end analysis also makes way for the following year’s strategic planning.
What is gross margin?
Gross margin or Gross profit margin is the terminology used to calculate the profit that is being marked by the company for the efforts throughout the year.
It is calculated by finding out the difference between the cost of goods and the sales revenue divided by sales revenue, which in turn will give us the percentage of profit earned or loss incurred by the business firm.
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The exact formulation stands at, The sales revenue minus cost of goods divided by the sales revenue will give us the exact percentile of the gross margin earned.
Use of Gross profit margin
- Companies mainly use gross margin to overlook the production overhead because that is where the capital is being spent. If the gross profit percentage is diminishing, the managers should look for the processing systems and analyse the cost reduction techniques like cutting cost on supplies and materials or choosing alternative production approaches etc.
- Competitor analysis is another segment that gross margin is used for. The higher the margin, companies gain credibility and recognition in the society. For example, If both companies TPO and ZRD are providing trading terminal softwares and ZRD offers the software at one fifth the cost of TPO, the sales revenue of ZRD will boost up. In the efforts of competing with one another, TPO increases the sales value which further decreases the margin as the demand for the product has reduced. TPO has untowardly lost the market share and gross margin in the course.
- It is best used to check the financial stability and growth of the company and used as a tool and an instrument to measure the cost incurred and the sales made out of the budget that was planned in the beginning of the financial year. If suppose, company A, has invested $15 million in the business and mid way through the commencement of business, the production head faces struggles of meeting other miscellaneous costs. He/she calculates the gross margin to arrive at the percentage which is dropping down which further leads to the assessment of the steps to be taken to retain revenue in spite of meeting all the additional expenses.
- This financial instrument also helps in allocating of the factory overhead charges. When gross margin is viewed on a trend line, even the slightest of changes are visible. Wherein the corrections can be made by further investigation and settle the costs and expenses of the production process to achieve higher percentage of the margin.
The importance of Gross margin
Gross margin is a derivative of the functions of the company. It is crucial that every company needs to keep track of it’s performance for the survival of itself. Without gross margin, the operational and miscellaneous expenses would not be recognized.
However, it is widely encouraged to be correlated with the inventory turnover ratio. The higher the inventory ratio means that the assets management of the company is at an appreciating level. As the inventories and the production process are combined together, keeping record of both and maintaining the balance among these instruments will support the financial upgradation of the company in both monetary and goodwill terms.