The gross margin ratio is one of the most common types of ratios used by businesses and business analysts when inspecting the performance of an organization over a period of time, typically a year. It compares the amount of sales generated to the cost it took to create the goods for sale. The result is a percentage of sales that counts toward gross profit. The higher the margin, the more efficiently the business is manufacturing goods. However, despite its usefulness, the gross profit margin ratio invites several difficulties.
The primary and most obvious difficulty with the gross profit margin ratio is that it covers only the gross profit. The ratio will only show the margin the business has leftover after all variable and direct costs of production are accounted for. This can be useful, but it leaves a wide swath of other expenses unaccounted for, including taxes, employee wages and other indirect costs. This is why it is usually necessary to examine both gross profit margin and net profit margin.
The calculations used to create the gross profit margin ratio can also run into difficulties. The primary part of the ratio, total sales, is often easy to calculate -- but not always. The business needs to decide whether to count all sales including those in accounts receivable that have not yet been paid, or only sales that have actually be paid. Choosing which costs directly impact production and which do not can also be difficult for many businesses.
Downward Trends and False Assumptions
A high gross profit margin can seem good for a business, but it can also blind a company to future conditions. A gross profit margin can drop slowly at intervals, falling year by year until the company is under financial pressure. If the business channeled all its extra money to research and development or expansion, it must suddenly pull back on its projects to accommodate the rise in costs that it did not see coming because the gross margin was positive years ago.
Gross profit margin also varies by industry, which can lead to some confusion. The airline industry, which has high costs like jet fuel, may have a typical gross margin of only a few percent, very low but expected. The software industry may have a gross margin as high as 90 percent because of its high sales numbers but low production costs. This is also considered normal. If a company does not match the gross margin ratio to the proper industry, the numbers can do little good in broad comparisons.