No matter how high your company’s gross margin ratio, it can still be a dangerous measurement to rely upon. Misconceptions about what the gross margin ratio represents run rampant in the business world. Only a full complement of business ratios can provide an accurate picture of financial success and stability.
Of all the financial ratios used by businesses today, the gross margin ratio is probably one of the most misunderstood. Untrained supervisors and employees frequently believe it is the company’s profit percentage – which is far from the truth. Simply stated, a company’s gross margin is calculated as the total sales less the total cost of goods sold. The gross margin ratio is then calculated by dividing the gross margin by the total sales. The ratio is meant to measure the operating efficiency of a company, and should be used only with a working knowledge of its purpose.
The biggest disadvantage of measuring a business with the gross margin ratio is that it does not take all costs into consideration. The calculation includes production costs such as labor, material and operating overhead expenses in the factory. However, it does not include selling or general and administrative expenses such as accounting, legal or human resource costs. Because of this limitation, the gross margin ratio is helpful only in tracking operations cost as a percentage of sales.
Many people ask, “What’s an acceptable gross margin ratio?” Unfortunately, there is no single answer to the question because every business is different. A company with a 40 percent gross margin ratio may look profitable; but, if selling and administrative costs account for another 35 percent of total sales, it doesn’t leave much to flow to the bottom line. For that reason, each company should use a full complement of financial ratios like EBIT (Earnings Before Income and Taxes) or Net Profit to understand the full picture of its financial position. Only then will you be able to establish a gross margin ratio target relevant to your business.
What matters most in any business is what goes to the bottom line -- after taxes. Net profit is the only way to truly compare business to business and industry to industry. The major disadvantage of the gross margin ratio is that it does not measure total profitability. Only when you subtract all costs -- labor, material, overhead, selling costs, administration, interest and taxes -- can you rightly determine company profit.